Supervisor: Morten Balling Dept. of Finance Author: Jasim Ali Rathore Reg. No. JR63269 MSc.

FIB

An OECD Perspective On

Corporate Governance
and Ownership Structure in

INDIA
2005

Denmark

A B S T R A C T
The concepts like Corporate Governance have been developed due to the needs of owners to supervise the management and influence the corporate decisions. All stakeholders try to influence the Corporate Decisions for their individual objectives, but efficient Corporate Governance codes (principles and practices) create balance among all stake holders, in terms of their individual rights. For the purpose of thesis, I will look upon several Corporate Governance Issues in INDIAN financial market, as means for investor/owner to exercise influence over, and supervise the company to increase the returns. An Active ownership is prerequisite for efficient Corporate Governance. The objective of study is to explore, how Indian corporate world perceives the concept of Corporate Governance, how they deal with Corporate Governance problems, and how Codes of governance could benefit each ones own objectives. The interplay between corporate facts (Ownership Structure, Market capitalization, ownership concentration, and market arrangements etc.) and legal environment develop Corporate Governance principles and practices over time.

Key Words:

Corporate Governance Codes, OECD Principles, Ownership Structure,

family Ownership, Domestic and Foreign Ownership and CG Committee.

P R E F A C E

Accomplishing this thesis has occupied most of my time and attention during this autumn. Although it has been an interesting and challenging task, which I feel has opened my mind to new knowledge. I learned how theoretical knowledge is used to analyze real world examples. It was my first effort, and I have really enjoyed writing my thesis. Provisions regarding Indian Corporate Governance code and recommendations for good governance practices are taken from the Report on CG by Shri Rahul Bajaj (December 1995), Kumar Mangalam Birla Committees report on CG (May 1999), Report on CG by a committee under chairmanship of Shri Narayana Murthy (February 2003), Companies Act 1956, and Clause 40 & 49 of listing agreement. I would like to thank to my Supervisor Morten Balling, for helping me to make my thesis better, through advice and guidance.

Aarhus, April, 30 2005.

Jasim Ali Rathore

II

TABLE OF CONTENTS
A B S T R A C T....I P R E F A C EII

1. INTRODUCTION
1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13 Background....1 Corporate Governance...1 Objective .......2 Problem Statement.3 Controlling Agency Cost....4 Empirical Studies Proof.4 Asias Governance Challenge.....5 New Corporate Governance Codes....6 Improving transparency...7 Enforcement of Regulations........7 The power of investors....8 Accepting change..10 Investors Awareness....11

2. OWNERSHIP STRUCTUREAn Overview....12

2.1.1 2.1.2 2.1.3 2.1.4 2.1.5 2.1.6 2.1.7 2.1.8 2.1.9 2.2 2.2.1 2.2.2 2.2.3 2.2.4 2.2.5 2.2.6 2.2.7 2.2.8 Resource Based Theory..12 Agency Theory...13 Institutional Theory.14 Share Holding Pattern.15 Studies on Indian Ownership Structure..16 Ownership & Firm Performance...17 Review of CG Literature18 Empirical Implications...19 Investor Protection and Emerging Markets... 19 Mergers & Takeovers Trend....24 Market for Corporate Control before Liberalization ..25 Regulations before Liberalization Era.25 Regulations in Post Liberalization Era26 Recent Evidence on Ownership Structure...27 Strands to the Corporate Misgovernance....29 Government still owns Big Stake....29 Structure of Corporate India...31 Stat Owned Enterprises......35

III

3. FAMILY OWNERSHIP....37
3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 3.14 3.15 Advantages...37 Disadvantages...38 Problems...38 Problems with Family-Owned Businesses in India......39 Cross Holdings..39 Family-owned Business in India...40 A Look in the History ..40 Family Business Successors.40 Characteristics of a Successor..41 Responsibilities of Successor..41 The Influence of Families on successor...41 The Largest Family-owned Businesses in India...42 What Indian Family-owned businesses have to do to compete in the Future.... 42 Mukesh Ambani admits to differences ...42 Conclusion...43

4. Domestic vs. Foreign Ownership ..44

4.1 4.2 4.3 4.4 4.5 4.6 4.7 Domestic ownership....45 Domestic financial institutions ...45 Domestic ownership and Group affiliation ....46 Foreign ownership...47 Positive affects of Foreign Corporate Ownership ..48 Foreign Corporate involvement in India 49 Conclusion ..51

5. Role of Governance Principles.52

5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.8.1 5.8.2 5.8.3 5.8.4 5.8.5 5.8.6 5.8.7 Families, Corporations and other Block-holders52 Management52 Financial Institutions...52 Improving Corporate Disclosure in India...53 Compliance.54 Award to Improve Governance Practices...55 Reward for well Governed Companies..56 Policy Initiatives.56 Approach57 Agenda of Committee57 Initiatives to improve Governance practices .58 Statutory Code of Governance...59 First Code of Governance ..59 Published Code of Governance..59 Implementation...60

IV

6. A Comparative Approach to OECD principles & Indian recommended Code of Governance

6. 6.1.1 I6.1.2 6.1.3 6.1.4 6.1.5 6.1.6 6.1.7 6.1.8 6.1.9 6.1.10 6.1.11 II6.2.1 6.2.2 6.2.3 6.2.4 III IV V6.2.5 6.2.6 VI 6.2.7 6.2.8 New OECD Principles...61 Revised Governance Principles....62 Ensuring the Basis for Effective Governance Framework.62 Key Constituents of CG.62 Board Composition63 Independent Directors63 Nominee Directors.64 Chairman of the Board..65 Insider Trading..65 Audit Committee...65 Whistle Blower Policy..67 Harmonization...67 CG Ratings ...67 Rights of Shareholders...69 Shareholders..69 Rights...69 Responsibilities70 Institutional Investors...71 The Equitable Treatment of Shareholders..72 The Role of Stakeholders in Corporate Governance..72 Disclosure and Transparency...73 Real and Timely Disclosure.75 Disclosure Related to Management.76 The Responsibilities of the Board.76 Implementation77 Conclusion...81

References
Articles, Working Papers, websites, Newspapers and Periodicals84

Enclosures.. 87
Market Capitalization for top 50 Indian Companies Clause 49 of Listing Agreement & Recommendations US GAAP & Indian GAAP Contents of Companies Act, 1956.

1.1

Background

Corporate Collapses like Enron, Global Crossing, and World Com have taught the investors that the issue of Corporate Governance can't be ignored. While conducting Fundamental Analysis, investors need to keep a close eye on the way companies keep management in check, and ensure financial disclosure, board independence, and shareholder rights. Recent studies suggest that the benefit of analyzing governance gives more than simply avoiding disasters. Good corporate governance can increase a company's valuation and boost its future profitability.

1.2 Corporate Governance

Basic understanding of theoretical framework is essential, to understand the analysis presented later on. Corporate governance means the way in which directors and auditors handle their responsibilities towards shareholders and other company stakeholders. The concept is built around the relationship between owners and management of the Company. To acquire new capital from Market, this relationship has to be built on trust and continuity. The objective of owners is to have return on their investment and management is responsible for operating the company. It is the management who is managing owners capital and in some ways is responsible for return. Corporate Governance deals with the issue, how suppliers of finance to corporations assure themselves of getting a return on their investment (Shleifer and Vishny 1997). Think of it as the system by which corporations are directed and controlled. The owners delegate powers with responsibility to the board, which in turn delegate it to the top management. Typical corporate governance measures include appointing non-executive directors, placing constraints on management power and ownership concentration, as well as ensuring proper disclosure of financial information and executive compensation. Surprisingly, corporate governance has been considered a secondary factor affecting a company's performance. As opposed to a company's financial position, strategy, and operating capabilities, the effectiveness of governance practices was largely seen as important only in special circumstances like CEO changes and Merger & Acquisition (M&A) decisions. But recent events prove that governance practices are not merely a secondary factor. When the company's Share price falls because of an accounting scandal, the importance of good governance practices become obvious. Corporate disasters show that the absence of effective corporate controls puts the company and its investors at tremendous risk. 1

1.3 Problem Statement

Industrial Development has played a central role in the development of developed and emerging economies. Contribution of industrial sector has always been significant proportion of GDP. Management codes or Governance practices have long term effects on growth and development of industrial sector. It would not be wrong to say, that the adequacy and the quality of corporate governance shape the future trend of any capital market and economy. Past few years have witnessed significant changes in the financial and corporate world. Following the Asian financial crisis, recent accounting scandals have increased the importance of an effective institutional framework that would help corporate management, to increase shareholders value while protecting the interests of other stakeholders. Efficient financial markets are based primarily on trust. Investors need to be able to trust in the relevance, reliability, completeness and timliness of information they receive.Big family name and long-term relationships may enhance the confidence level of investors in Asian companies.

Top-level officials from China, Singapore, and the Philippines are vowing to improve the corporate governance of their national companies because investors are using the same standards to assess firms in developed and developing countries.1 In an emerging market, technical and financial assistance is of utmost importance, to the SEC for development, and implementation of good corporate governance practices, and establishing a sound regulatory framework. This involves implementation of the Code of Governance, stakeholder awareness, capacity-building and networking with other emerging markets. In order to attract sustainable capital, it is imperative for economies in transition to focus on evolving a system that ensures good corporate governance.

As the dust settles after the Asian financial crisis, most economic and development commentators feel that a major determinant of the relationship between long-term economic growth and poverty reduction is a well-functioning financial and corporate sector. The inflow of foreign capital brings with it technology and managerial skillsfactors crucial to the developing countries in their economic progress. At the same time, the confidence of local investors also heightens. This increased economic activity improves human welfare in the form of an efficient allocation of resources and more

J. Hodges 2001, Raising confidence in the east

employment. Therefore, implementing good governance practices has a positive impact on economic growth, which creates opportunities and brings people above the poverty line.2 Corporate Governance committee, which acts as a resource centre and carries out research and awareness campaigns for different stakeholder on various issues related to corporate governance, can play long term role in the development of industrial and financial sector. Guidelines and newsletters could also be distributed to the corporate community for a better understanding of the issue, and research for the harmonization of the provisions of the Code with corporate laws (Co. law, listing agreement, and provisions related to M&As.) and an assessment of the state of corporate governance is also important. A briefing series can be initiated to further increase public awareness on various aspects of corporate governance. In order to generate meaningful debate, extensive research work is important for focusing on the role of institutional shareholders in the promotion of corporate governance. Another major initiative of CG Committee could be the development of corporate governance index to indicate assessment of practices and policies and to reflect the relative level to which a company accepts and follows the Code and guidelines for improvement. The exchange of contemporary ideas and collaboration on key issues, SEC officials should participate in study tours to leading international institutions that are involved in the promotion and development of sound governance practices. In order to encourage participation of stakeholders in the system, it is essential to broaden their understanding of the subject. In this regard, the SEC should conduct several activities, including seminars and workshops, to increase the awareness about directors and management of listed companies of their statutory and fiduciary duties.

1.4 Objective
The purpose is to explore how corporate sector in Indian Financial Market developed Corporate Governance practices over time. Furthermore, we will also look how ownership structure effects control mechanism. The role of independence of board and audit committee is also vital for stakeholders rights. Governance issues may be examined in detail from various perspectives to guide policy decisions on; (1) Principal-agency problem (2) Structure of board and its functioning (3) Ownership structure and the role of controlling shareholders.
2

By Shahnawaz Mahmood, UN development project on Corporate Governance practices in Pakistan, 2002.

(4) The interests of shareholders relative to balancing the interests of stakeholders. (5) Adequate and effective institutional arrangements financial markets in particular, necessary for mobilizing and deployment of savings of society more efficiently.

1.5 Controlling Agency Cost

The theoretical literature on corporate governance proposes six main different mechanisms to control agency costs. 1- Ownership Structure (Jensen and Meckling 1976) (Shleifer and Vishny 1986) 2- Capital Structure & Board Structure (Jensen 1986), 3- Managerial Remuneration (Jensen and Mourphy 1990) 4- Product Market Competition (Hart 1983) 5- Takeover Market (Shleifer and Vishny 1988, Fama and Jensen 1983, Jensen and Warner 1988). 3 Empirical literature sheds light on relative weight of these counteracting mechanisms, suggesting that firm value is an outcome of control conflicts. As Large shareholdings are common in the world, except the US and the UK La Porta et. al (1999). Giving large share-holders incentive to collect information and to monitor management reduces agency costs (Shleifer and Vishny 1986).

1.6 Evidence from Empirical Studies

For years, investors ignored corporate governance because academic research found no clear causal link between governance and financial performance. But that view is starting to change now with the changing Corporate Practices. A recent paper concludes that investors that sold US companies with the weakest shareholder rights and bought those with the strongest shareholder rights earned an additional return as high as 8.5%. 4The study analyzes 1,500 companies and ranks them based on twenty four corporate governance provisions. Those companies with the lowest rankings were less profitable and had lower sales growth. Moreover, the returns on these companies lagged far behind those of higher ranked firms. The paper also shows that for each one-point increase in shareholder rights, a company's value increased by 11.4%.
3
4

Megginson & Netter 2001, and Shleifer & Vishny 1997). "Corporate Governance and Equity Prices, Harvard and Wharton, quarterly Journal of Economics, February 2003.

A study produced in 2000 by McKinsey5 found that 75% of the 200 institutional investors it surveyed regard board practices as important as financial metrics for assessing companies. The study shows that companies that moved from the worst to the best governance practices could expect a 10% increase in market valuation, which means good governance practices are positive signal to potential investors.

1.7 Asias Governance Challenge

The financial crisis that overran much of Asia in the late 1990s, prompted most of the affected countriesjoined later by Indiato improve their corporate governance practices. Nearly all of them now require listed companies to have independent directors and audit committees (Exhibit 1).Most countries in the region have adopted explicit governance codes (see "Why codes of governance work6"). Securities laws and the listing requirements of stock exchanges have been strengthened. The regulatory authorities, and the media are more curious and probing.

Across Asia, too many companies remain unconvinced of the value of good governance. Moreover, the institutions need to ensure good governancejudicial systems, capital markets, long-term institutional investors that can push for better governancecontinue to be underdeveloped in most of these
5 6

Source: www.mckinseyquarterly.com/home.asp www.mckinseyquarterly.com/ab_g

countries. Laws and regulations arent enforced rigidly; well-trained accountants and other professionals are scarce.The starting point for reform in Asia is therefore different from Europe or North America. Asian governments, corporate leaders, investors, and regulators realize that corporate-governance practices wont change overnight, so patience is needed. Getting companies to comply with new rules is a very slow process, requiring greater transparency and better enforcement in boardrooms.

1.8 New Codes for Good Governance

New CG laws and codes are important because they set the stage for change. But given the vast differences in ownership structures, business practices, and enforcement capabilities, merely adopting new requirements like US or Western Europe would be a mistake. Consider the question of requiring CEOs or CFOs to certify the financial reports of their companies. In much of Asia, directors and officers are already liable for fraudulent financial reporting., yet some of these countries are thinking about replicating the certification requirements under the US Sarbanes-Oxley Act. It would be hard to enforce, since under Sarbanes-Oxley standards they would require proof that a CEO or a CFO had "willfully" violated them or knew that a financial statement was false. Such a subjective yardstick would be difficult to establish, particularly with underdeveloped judicial systems.The requirement that boards should include a majority of directors who are truly independent may also be unrealistic: it is essential to have some, but in most cases this might not be feasible. The pool of qualified independent directors is small in many Asian countries. Where confidentiality provisions in contracts are difficult to enforce, companies may be reluctant to give any outside director too much insight into their performance or strategy for fear that this information might be used against them. For many Asian corporations that have a single majority owner, such a requirement might be unfair; even the NYSE and Nasdaq dont have one (though both require these companies to have wholly independent audit committees).Any Asian government should therefore rank the reforms in order of priority and tailor them to the countrys needs. Ensuring that local laws and codes are consistent with the OECD Principles of Corporate Governance, would be a good start. It would be much better to enforce basic reforms vigorously than to adopt requirements that go unheeded.

1.9 Improving transparency

Without greater transparency, new laws and governance codes will do little to build investor confidence. The recent reforms, accounting standards in many Asian countries remain weak. Not enough professionals have an in-depth understanding of local or international accounting standards. As a result of all this, reported earnings, cash flows, and balance sheets can be quite unreliable. Disclosure requirements and auditing practices are improving, however, as national financial-reporting standards are gradually being harmonized with international standards This will really enhance effective corporate governance. The independence of external auditors is being boosted as well. The Chinas Securities Regulatory Commission (CSRC), for instance, now forces companies to rotate their senior external auditors every five years. Other places, including Hong Kong, India, and Thailand, are also exploring such a requirement. Soon, it will apply to banks in Singapore, where external auditors of public companies also can no longer provide certain nonaudit services (for instance, bookkeeping and internal auditing) to their existing audit clients.

1.10 Enforcement of Regulations

Although most countries are strengthening their accounting standards and adopting minimum CG rules, many are lagging behind in enforcement (Exhibit 2). Compratively smaller gap between New Regulations and Enforcement in INDIA and CHINA, while SINGAPORE with best figures in the region. The problem is,. that business and political circles are closely intertwined, and the mechanisms for managing conflicts of interest are underdeveloped. In addition, the desire of governments to promote short-term economic growth makes them less willing to go after large corporations to protect minority shareholders. Thailand has seen several high-profile cases of corporate misconduct in which the party under investigation, despite strong evidence , eluded prosecution because law-enforcement authorities failed to act. Often, regulators dont have large enough staffs or budgets to conduct rigorous investigations. And with legal systems still underdeveloped, prosecuting cases is difficult. Most governments, however, are

spending more resources to monitor companies7 and enhancing the authority of their regulators, some of which are now getting tougher. In Hong Kong, regulators and the police are cooperating to combat financial crime.

1.11 The power of investors

In principle, investors and creditors could pressure companies to comply with new governance requirements (Exhibit 3). In practice, most of the regions investorsdomestic and foreignare reluctant to get involved. They invest in a company if they believe that its growth prospects and risk premium outweigh all other factors and tend to sell their holdings rather than challenge management when governance problems arise. The local institutional investors largely bet on short-term price movements rather than long-term growth prospects. Investors must become more vocal in support of
7

The Office of the SEC, Thailand, is devoting additional resources to monitor disclosures by listed companies and has announced that it will step up its investigations of internal fraud and insider trading by executives.

reform and more willing to engage management. Improved financial reporting and broader disclosure will help and reforms will make it easier for minority shareholders to vote by proxy, to nominate and elect directors, and to raise questions at annual meetings.

To promote participation by investors, China is thinking to allow them to vote online on major decisionsto issue shares, for example.Some investors actually are making their contribution to

improve corporate governance. A number of local Thai funds, asset-management firms, and life insurance companies that collectively manage $23 billion in assets, have formed the Institutional Investor Alliance to promote better corporate governance in Thailand. The Securities Investors Association of Singapore works with companies to nominate independent directors and hopes to collaborate with fund managers to improve governance in the companies in which they invest.Creditors are also playing their role: Kookmin Bank, in South Korea, now Issues loan to midsize corporate borrowers with lower interest rates for meeting specified governance standards. Moreover, the regions media is becoming noticeably more willing to probe management practices.

Malaysias business weekly The Edge regularly features CG issues and warns its readers about questionable conduct in local companies.8

1.12 Accepting change

Since corporate governance is a new concept in most parts of Asia, raising awareness is a vital element of any reform effort. Many directors, are unaware of their fiduciary obligations and view their directorships as Position, without real responsibility. So, the institutes in Hong Kong, Singapore, and Thailand now offer seminars and training programs for directors and officers. Region-wide organizations, such as the Asian Corporate Governance Association, have been formed to promote understanding and reform. Whats more, several regional groups, including CLSA (a regional brokerage firm), Thai Rating and Information Services, and Indias ICRA, publicly rate the governance practices of listed companies. Some Asian companies themselves have started reform. Indias Infosys Technologies discloses the extent of its compliance with ten corporate-governance codes, reconciles its financial statements with eight accounting standards (including the US and UK GAAP), and has a board with a majority of independent directors as well as wholly independent audit, nominations, and compensation committees. Exemplary companies can also be found in other parts of Asia. CLP5 (Hong Kong), POSCO (South Korea), Public Bank (Malaysia), Siam Cement (Thailand), and Singapore Telecommunications (Singapore). These few have been recognized by publications and organizations for their good CG practices. Moreover,there are companies that have put in place the basic governance structuressuch as boards of reasonable size, with some independent directors. Many boards that look good on paper have yet to fully embrace their duties as looking after the rights of minority shareholders. These boards should ask management tough questions, actively helping to set corporate strategy, monitoring risk management, and ensuring that companies set and meet their financial and operating-performance targets. The new forms of behavior will undoubtedly take time to establish efficient Governance practices. Some companies have recruited experienced foreign directors to help overhaul board practices.

Source: McKinsey Investors Opinion Survey, 2002.

10

Corporate governance has undoubtedly improved in Asia. Some countriesSingapore in particular have made significant progress. To move ahead, both governments and companies in Asia must do their part. Companies should create stronger and more purposeful boards; enhance the scope, accuracy, and timeliness of financial reporting; and pay more regard to the rights and interests of minority shareholders. Governments should provide a strong legal and regulatory framework. While specific provisions will differ from one country to the next, any reform effort must include elements such as strict corporate and securities laws, tough accounting standards, strong regulators, efficient judicial systems, and determined efforts to reduce level of corruption.

1.13 Investors Awareness

Investors are getting help in steering clear of misgoverned companies and finding well-governed ones. Governments, stock exchanges, and securities watchdogs are coming up with new rules and regulations that try to put a stop to some of the worst cases of corporate failure. Governance metrics can provide governance performance ratings.

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2. Ownership Structure
A firms ownership structure influences its performance for several reasons. Firstly, differences in identity, concentration and resource endowments among owners determine their relative power, incentives and ability to monitor management. Shareholdings by corporations, individuals, banks, mutual funds and governments are well-known examples of this phenomenon. Secondly, as owners have divergent goals, they have different influences on firm performance. For example, financial investors may be interested in short-term returns on their investment, while corporate investors may be more inclined towards establishing a long-term relationship. In emerging and transition economies external mechanisms are less developed, and therefore, governance of listed corporations takes place mainly through internal mechanisms. Furthermore, institutional factors like family-run business groups play a distinctive role. Government controlled financial institutions are often important shareholders and have incentives and objectives quite different from those of private investors. Consequently, the effect of ownership on performance in emerging economies is likely to be different. La Porta et al. (1999) highlight the preponderance of block holdings in general and familial holdings in particular among non Anglo-Saxon economies. The two most important categories of foreign shareholders namely, foreign financial institutions and foreign industrial corporations have different motivations. The aggregation of them into one common class of shareholders, mix certain important results which can only be determined, if they are analyzed separately. Foreign ownership is undoubtedly an important component in the shareholding of firms in many emerging countries, and it is far from being the largest block of shareholding in these countries. Studies 9 find that domestic corporations, which constitute the largest proportion of shareholdings in Indian corporations, also perform a significant role. They observe that the influence of domestic corporations is conditional on business group affiliation of firms.

2.1.1 Resource Based Theory

Financial - foreign shareholders are endowed with good monitoring capabilities, but their financial
focus and emphasis on liquidity results in them unwilling to commit to a long-term relationship with the firm and to engage in a process of restructuring in case of poor performance. These shareholders prefer
9

FOREIGN AND DOMESTIC OWNERSHIP, BUSINESS GROUPS AND FIRM PERFORMANCE Rejie George, October 2003. Tilburg University and Cochin University

12

strategies of exit rather than voice to monitor management (Coffee, 1991; Aguilera and Jackson, 2003). Consequently, financial - foreign shareholders are postulated to have a moderate impact on firm performance.

Financial - domestic shareholders possess characteristics that represent the worst of both worlds.
Their financial focus leads to short-term behavior and a preference for liquid stocks while their domestic affiliation often results in a complex web of business relationship with the firm and other domestic shareholders (Claessens et al., 2000; Dharwadkar et al., 2000). Therefore, these shareholders are expected to have a negative influence on firm performance. On the other hand, there are domestic and foreign shareholders who possess strategic interests because their ownership stakes are motivated by non-financial goals, such as obtaining control rights. (Aguilera and Jackson, 2003).

Strategic foreign shareholders use their ownership stakes as a means to foster their strategic
interests, which involve securing access to new markets, location specific resources and low cost production facilities. Their foreign affiliation also gives domestic firms relatively easy access to superior technical, managerial and financial resources (Chibber and Majumdar, 1999). Therefore, their impact on firm performance is projected to be superior.

Strategic domestic owners exercise property rights as a means to pursue the strategic interests of
their organizations which include regulating competition between firms, underwriting relational contracts, securing new markets etc. (Aguilera and Jackson, 2003). However, their impact on firm performance is anticipated to be moderate because, in comparison to strategic - foreign shareholders, they have relatively inferior resource endowments and capabilities.

2.1.2 Agency Theory

If shareholders have interest to indulge in monitoring managerial behavior, then shareholders differ with respect to incentives to spend resources on monitoring. Shareholders who own a small proportion of a firm have very little incentive to devote the necessary time and effort on voicing their view on account of free riding from other shareholders. Dharwadkar et al. (2000) argue that firms in emerging economies are especially characterized by unique agency problems arising from principal - principal goal incongruence. This is in addition to the traditional agency problems based upon principal - agent goal incongruence as observed in many Anglo-Saxon economies. The principal - principal goal incongruence in emerging economy firms stems from expropriation within weak governance contexts when large or majority owners assume control of the firm and deprive minority owners the right to appropriate returns on their investments (Claessens et al., 2000; Lemmon and Lins, 2003). 13

2.1.3 Institutional Theory

Above given perspectives to study the impact of ownership on firm performance, do not examine the social context within which the firms activities are embedded. Institutional theory addresses this important issue by introducing the social and regulatory context in influencing organizational structure and firm behavior. Thomsen and Pedersen (2000) in their study argue that both ownership concentration and identity are embedded in national institutions and these have to be taken into account when accessing implications for corporate strategy and performance. Institutional theory emphasizes the influence of socio-cultural norms, beliefs and values, regulatory and judicial systems on organizational structure and behavior. Institutions regulate economic activities through formal and informal rules as a basis for production, exchange and distribution (North, 1990).The emerging economies are characterized by greater imperfections in the markets for capital, products and managerial talent. These lead to so called institutional voids. Business groups are particularly well suited to provide the necessary welfare enhancing functions to plug these institutional voids because of their superior ability to raise capital, train and rotate managerial talent among group firms, and use common brand names in marketing their products. Although, some of these institutional voids and ineffective protection of minority shareholder and creditor rights lead to greater entrenchment by controlling shareholders resulting in conditions ideally suited for expropriation of weak stakeholders.

Combining the agency, resource-based and institutional theories reveals the differing
influences of various categories of shareholders among emerging economy firms. Broadly, they indicate that there exists a positive reinforcing effect on firm performance if the shareholder is outside, concentrated, foreign and has strategic resources. On the other hand, there are negative reinforcing effects if the shareholder is inside, dispersed, domestic and has financial interests. The reinforcing effects are more severe when the agency and resource based characteristics of these shareholders are in emerging economy institutional settings. The inside, concentrated, domestic shareholders with strategic interests are resource rich from the resource-based perspective but are subject to incentive distortions when viewed from the agency framework. On the other hand, outside, dispersed, foreign shareholders with a financial focus tend be resource poor from the resource based perspective but have relatively more aligned interests from an agency perspective.

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2.1.4 Share Holding Pattern

The Indian Corporate Sector has several hundred firms. It is large by emerging market standards and the contribution of the industrial and manufacturing sectors value added is close to that in several advanced economies. Unlike several other emerging markets, firms in India, typically maintain their share-holding pattern over the period of study (Patibandla 2002), making it possible to identify the ownership affiliation of each sample firm with clarity. The legal framework for regulation of all corporate activities including governance and administration of companies, disclosures, share-holders rights, has been in place since the enactment of the Companies Act in 1956 and has been fairly stable. The listing agreement of stock exchanges has also been prescribing on-going conditions and continuous obligations for companies. 10 Although the Indian Corporate Sector is a mix of government and private firms

(which are again a mix of independent firms and those owned by business group families and multi nationals. J Kumar provides evidence based on 8 Indian Manufacturing Industries over the period of 1990 to 1999. Percentage share-holding of different investors (FORE, FII, CORP, and DIR) are correlated. 1t reveals that the mean DIR (Directors Share Holding) ownership level of the whole sample is 14.34% with a standard deviation of 18%. The mean percentage share holders holding of FORE, in the whole sample is 14.08% with a standard deviation of 17.66%. Corporate Share holding mean ownership level of the whole sample is 24.73% with a standard deviation of 18.78% and Financial Institutions mean share holding is 14.08% with a standard deviation of 16.08%.

Category Directors Shareholding Foreign Investors Corporate Share Holding Financial Institutions

Mean Ownership 14.34% 14.08% 24.73% 14.08%

Standard Deviation 18% 17.66% 18.78% 16.08%

The following table describes the dominance of corporate holdings and ownership by directors and their relatives. Different types of companies have different equity ownership pattern, in 1567 manufacturing firms.
10

For more discussion on this see pg. 249, (OECD 2001).

15

Pattern of Equity Ownership in different types of Companies

2.1.5 Studies on Indian Ownership Structure

Chibber and Majumdar (1998), using industry level survey data (ASI), compare performance of SMEs, and private Indian firms for 1973-89. SMEs account for 37% of employment and 66% of capital investment in 1989. They document that efficiency scores averaging 0.975 for private firms are significantly higher than averages of 0.912 for MEs and 0.638 for SEs. Ahuja and Majumdar (1998), Majumdar (1998a: b), discuss the relationship between the levels of debt in the capital structure and firm performance. While existing theory shows a positive relationship, data reveals negative relationship. A supply of loan capital is government- owned, support privatization. They conclude that a higher level of debt is associated with higher level of performance. Bad loans are possible in case of state owned financial institutions. The greater the level of debt in the capital structure, the lack of effort on the part of the managers, unlike the situation where privately owned debt suppliers can exercise a check on discretionary managerial behavior. When, the state-owned financial institutions primarily supply debt capital, a negative relationship will be noted between the level of debt and performance.

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Chibber and Majumdar (1998: 1999), test the influence of foreign ownership on performance of firms operating in India. Foreign ownership is found to have a positive and significant influence on firm performance, but it only does so when it crosses a certain threshold, and one that is defined by the property rights regime. Sarkar and Sarkar (1999: 2000), provide evidence (for 1995-96) on the role of large shareholders in monitoring company value. They find that block-holdings by Directors Increases Company value after a certain level of holdings, however they do not find any evidence of active governance from Institutional Investors. They also highlight that foreign equity ownership has a beneficial effect on company value. They find that for each type of large shareholder, the incentives for monitoring, changes significantly when ownership stakes rise beyond a particular threshold. They document that foreign ownership has a beneficial effect on company value. Khanna and Palepu (1999: 2000), using business groups level data from 1993 find that firm performance initially decline with group diversification and subsequently increase once group diversification exceeds a certain level. Gupta (2001), using firm level data of government owned firms from 1993-98, document that even the sale of minority stakes has a positive impact on firm performance and productivity. She finds that privatization and competition have a complementary impact on firm performance. Patibandla (2002), using firm level data from 1989 to 1999 from CMIE, show that foreign ownership is positively related with the firm performance.

2.1.6 Ownership and Firm Performance

Several Studies have examined the relationship between managerial ownership and firm performance. Most of the studies provide general support for the argument that increase in managerial ownership increases firm performance. However, these results have been questioned recently. Jayesh Kumar empirically examines the effects of ownership structure on the firm performance, from an 'agency perspective'. He examines the effect of interactions between corporate, foreign, financial, institutional, and managerial ownership. He doesnt find any evidence that the differences in Ownership structure, affect firm performance. He explores the link between firm value and share-holding pattern in a panel of 530 publicly traded Indian Corporate Firms, from 1991 to 1999. It uses exact share-holdings by different groups of owner, controlling for change in firm value due to small change in share-holding pattern (not exactly changing the dominance of a group). Where as, some firm specific controls, do react significant effect on firm performance. For example, age and size has a positive effect on firm performance with decreasing rate, advertising intensity, export intensity, marketing intensity and import intensity have 17

positive and significant effect on firm performance. Leverage has a negative effect on firm performance. No evidence is found for R&D intensity. However, the analysis does find evidence for the effect of share-holding pattern on firm performance if we do not control for the unobserved firm heterogeneity.
Jensen and Meckling (1976), integrate elements from the theory of agency, the theory of property rights

and the theory of finance to develop a theory of the ownership structure of the firm. They suggest that there is an optimal ratio of insider to outsider ownership. When the expected economic gains from investment in a firm are higher than the organizational and coordination costs, investor will choose to invest. Otherwise, available alternative will be chosen. That is, the process of weighing costs and benefits of various ownership structures will shape the investors preferences. The conceptual framework, inspired mainly by Barbosa and Louri (2002), the optimal ownership structure is assumed to be chosen optimally from a process of weighing costs and benefits of various ownership structures. That is to say that a firms' performance does not depend on the ownership structure and in long run, investors choose an optimal mix of insider Vs outsider ownership, provided there is no restriction on the share holders holding, was the case in India few years back. Share holdings differ by percentage of equity owned by investors, since an investor may choose to own the equity based on various economic or strategic reasons. Whereas firms performances, in terms of higher market share holders and profits, may depend on the ownership structure. Jensen and Meckling (1976), Shleifer and Vishny (1986), proposes that large investors are able to protect their investment better than large number of small investors, because of their incentive and ability in controlling the agency costs. Chibber and Majumdar, analyzes the relation between foreign ownership and company performance. (Khanna and Palepu 1999: 2000) examines the firm performance of group vs. stand alone firms. Sarkar and Sarkar (1999: 2000) examine the firm performance with the relation to effective monitoring by owners of companies. However, none of the studies have tried to look into the question with a wider prospective in view of corporate governance.

2.1.7 Review of CG Literature

The separation of ownership and control has been a long-standing concern in corporate finance. The conflict between managers and owners has been studied extensively by researchers seeking to understand the nature of the firm. (Berle and Means 1932) claimed that the increasing professionalism of management would lead to firms being run for the managers benefit rather than for owners. The principal-agent framework is used by Jensen and Meckling (1976), to explain the conflict of interests between managers and share-holders. The agency problem, developed by Coase (1937), Fama and 18

Jensen (1983), Jensen and Meckling (1976) is an essential part of the contractual view of the firm. A rich empirical literature has investigated the efficiency of alternative mechanisms. A rather small literature has attempted to test directly, Berle and Means hypothesis: managers fail to maximize firm value
where they are not themselves significant share-holders.

The empirical evidence on this point is mixed. Using US data from early 1930s, Stigler and Fridland (1983) found no evidence in favor of Berle and Means hypothesis. Similarly, using recent data Demsetz and Lenn (1985), found no relation between firm performance, and ownership concentration. While Ahuja and Majumdar (1998), Chibber and Majumdar (1998: 1999), Khanna and Palepu (1999: 2000), Majumdar (1998a: b), McConnell and Servaes (1990), Patibandla (2002), Mork, Shleifer and Vishny (1988) and Sarkar and Sarkar (2000) found a significant relation between firm value and ownership concentration. These findings have recently been questioned by Agrawal and Knober (1996), Himmelberg et. al (1999) and Habib and Ljungquist (2000), they find no evidence for the relationship between firm value and managerial stock-holdings, and concluded that managerial stock-holding are optimally chosen over the long run. Studies have examined ownership and performance relationships using agency theory as theoretical framework.

2.1.8 Empirical Implications

If complete contracts could be written and enforced, ownership structure should not be a matter (Hart 1983, Coase 1960). In general, public sector firms are argued to be less efficient than private sector firms (in relatively competitive markets) due to low powered managerial incentives. There could be political" reasons, as government pursues multiple objectives, some of which, unlike profit maximization, are hard to be contracted upon. Ownership in such cases makes a difference, when unforeseen contingencies arise, which are not contracted. The long string of agency relationship that characterize today's large firms, and the impossibility to write complete contracts between principals and agents on the exact tasks of the latter. As governance structures can be seen as a mechanism for making decisions that have not been specified by contract, Firms find themselves following conflicting incentives; neither public interest nor the commercial objectives are met.

2.1.9 Investor Protection and Emerging Markets

Recent studies conclude that the average firm-level governance is lower in countries with weaker legal systems. They find that governance is correlated with the extent of the asymmetric information and 19

contracting imperfections that firms face. Studies also find that better corporate governance is highly correlated with better operating performance and market valuation. Finally, firm-level corporate governance provisions matter more in countries with weak legal environments. This suggests that firms can partially compensate for ineffective laws and enforcement by establishing good corporate governance and providing credible investor protection.11 Firms can improve investor protection rights by increasing disclosure, selecting well-functioning and independent boards, imposing disciplinary mechanisms to prevent management and controlling shareholders from engaging in expropriation of minority shareholders, etc. Therefore, it is likely that firms within the same country will offer varying degrees of protection to their investors. Recent papers have studied firm-level corporate governance mechanisms, but most of these studies have concentrated almost exclusively on OECD and US countries (see Shleifer and Vishny, 1997, and Maher and Andersson, 2000.).Paper by Gompers, Ishi, and Metrick (2001) used differences in takeover defense provisions to create a corporate governance index of US firms, found that firms with stronger shareholder rights have better operating performance, higher market valuation, and are more likely to make acquisitions. However, there was no empirical evidence on the differences in firm-level governance mechanisms across firms in emerging markets. The relationship between the country level legal infrastructure and firm-level corporate governance mechanisms is far from obvious. One assumption is that firms in countries with weak laws would want to adopt better firm-level governance to counterbalance the weaknesses in their countrys laws and their enforcement and signal their intentions to offer greater investor rights. This would suggest a negative correlation between the strength of firm-level governance and country- level laws. A second possibility is that in countries with weak laws the degree of flexibility of firms to affect their own governance is likely to be smaller (i.e. the firm is likely be constrained by the country- level legal provisions). LLSV (1998) argued that greater investor protection increases investors willingness to provide financing and should be reflected in lower costs and greater availability of external financing. This suggests that we should find that firms with the greatest needs for financing in the future will find it the most beneficial to adopt better governance mechanisms today. Finally, question could be whether or not firm-level differences in corporate governance matter for future performance, market valuation, and access to external finance. CLSA report show that companies
11

Corporate Governance, Investor Protection, and Performance in Emerging Markets, Leora F. Klapper & Inessa Love, April 2002

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ranked high on the governance index have better operating performance and higher stock returns. First, we observe that there are well- governed firms in countries with weak legal systems and badly governed firms in countries with strong legal systems. However, we find that the overall firm- level governance is strongly positively related to country- level measures of investor protection, i.e. average governance is higher in countries with stronger legal protection. For example, increasing the country- level index of efficiency of the legal system from the low to the median value increases the average firm- level governance by about half a standard deviation, a large and economically significant effect. This supports the argument that firms have limited flexibility to affect their governance, which implies that improving the country- level efficiency of the legal system is likely to lead to an increase in the average firm- level governance. Firm- level determinants of governance support the idea that a growing firm with large needs for outside financing has more incentive to adopt better governance practices in order to lower its cost of capital. Therefore, firms operating with higher proportions of intangible assets may find it optimal to adopt stricter governance mechanisms to signal to investors that they intend to prevent the future misuse of these assets. F. Klapper finds that better CG is associated with higher operating performance (ROA) and higher Tobins-Q. He suggests that improvements in governance relative to the country-average are more important than the absolute value of the index. He tests whether good CG matters more or less in countries with weak shareholder protection and judicial efficiency. Firm- level governance matters less in countries with weak legal systems. An alternative is that in countries with weak legal systems, investors would welcome even small improvements in governance relative to other firms, in that case we will find that good governance matters more in bad legal environments. The results suggest that good governance practices are more important in countries with weak shareholder rights and inefficient enforcement. This finding suggests that recommending firms to adopt good governance practices is even more important in countries with weak legal systems. As already argued, that a growing firm with large needs for outside financing has more incentive to adopt better governance practices in order to lower its cost of capital. The growth opportunities are reflected in the market valuation of the firm, thus inducing a positive correlation between governance and Tobins-Q.

Himmelberg, Hubbard, and Palia (1999), argued that the degree of managerial ownership is
independently determined by a firms contracting environment. As managerial ownership is only one of many governance mechanisms, this argument could be easily transferred to other mechanisms such as managerial compensation, board structure, disclosure, and other minority shareholder protections.

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The most obvious causes of variation in contracting environments is the overall country- level measure of shareholder rights and their enforcement. For example, if a country's laws offer weak shareholder protection it might be costly for firms to adopt different provisions in their corporate charters because it will be difficult for investors and analysts to understand non-standard contracts. Therefore, firms in countries with overall weak legal environments may not have much flexibility to improve their own investor protection and may consequently have lower CG indices, on average. In this case we should expect a positive relationship between the quality of country level legal systems and the average of firmlevel governance indices within each country. If firms could completely overwrite the legal code in their own contracts, we would observe better governance in countries with bad legal systems as these firms would be more in need of good governance mechanisms to compensate for their bad legal systems. In this case we would observe a negative relationship between country- level legal systems and firm-level governance mechanisms. However, this case is very unlikely as a large body of evidence shows that the legal system does matter, most likely because if the enforcement of contracts is weak, then firms will be unable to overwrite their countrys legal system and their flexibility to improve their corporate governance would be limited. The composition of a firms assets will affect its contracting environment because it is easier to

monitor and harder to steal fixed assets then soft capital. Therefore, a firm operating with a higher proportion of intangible assets may find it optimal to adopt stricter governance mechanisms to prevent misuse of these assets, i.e. we would observe negative correlation between the proportion of fixed assets and governance. Firms with good growth opportunities will need to increase external financing in order to expand and may therefore find it optimal to improve their governance mechanisms as better governance and better minority shareholder protection will be likely to lower their costs of capital. The effect of size is ambiguous as large firms may have greater agency problems (because it is harder to monitor them or because of the free cash flows argument of Jensen, 1986) and therefore need to compensate with stricter governance mechanisms. Alternatively, small firms may have better growth opportunities and, as implied by the argument above, greater need for external finance and better governance mechanisms. We expect that since reporting standards and investor protection in the US are much higher than in most other countries, firms in emerging markets would be required to improve their CG provisions in order to list overseas.

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Klapper 12 finds that (1) firms in countries with weak overall legal systems on average have lower governance rankings, however there is no systematic relationship between the variation in firm-level rankings and country- level legal efficiency; (2) past growth rates are positively associated with good governance; (3) firms with higher proportions of fixed assets have lower governance; and (4) firms that trade shares in the US have higher governance rankings. His results suggest that the relationship between good governance and market valuation holds regardless of firm size. His measure of capital intensity, K/S, which is significantly negative, suggests that firms with more intangible assets (i.e. lower capital intensity) have higher Tobins-Q. He also finds that firms with weaker corporate governance have relatively lower profits in the US. However, this is the first evidence that a relationship between corporate governance and firm performance holds across several emerging markets, which unlike the US are categorized by more concentrated ownership and weaker legal environments. This is consistent with La Porta, et al (2002) that finds evidence in 27 high- income countries that firms with better protection of minority shareholders have higher market valuation. He finds that this interaction between firm-level governance and country- level legal efficiency is negative, which indicates that governance is more important in countries with overall weak legal systems. The legal system matters less for the wellgoverned firms, which is plausible because firms with better governance will have less need to rely on the legal system to resolve governance conflicts. Firm- level investor protection is more important for firm valuation in countries with weaker investor protection from the courts. Although an improvement in firm-level governance always improves performance and market valuation, the improvements are higher in countries with weaker legal and judicial infrastructures. Firms that trade shares in the US have higher governance rankings, especially so in countries with weak legal systems, good governance is positively correlated with market valuation and operating performance and this relationship is stronger in countries with weaker legal systems. One interpretation of the last result is that firm-level corporate governance matters more in countries with weak shareholder protection and poor judicial efficiency. An alternative interpretation is that the legal system matters less for the well- governed firms, because firms with better governance will have less need to rely on the legal system to resolve governance conflicts. The results suggest that firms in countries with poor investor protection can improve their corporate governance, which may improve their performance and valuation.

12

Corporate Governance, Investor Protection, and Performance in Emerging Markets, Leora F. Klapper,

April 2002

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He also finds that firms have on average significantly lower governance rankings in countries with weak legal systems, which suggests that firms cannot completely compensate for the absence of strong laws and good enforcement. Although he doesnt find that firms can independently improve their investor protection and minority shareholder rights to a certain degree, this could be a second best solution and does not fully substitute for the absence of a good legal infrastructure. Although reforming investor protection laws and improving judicial quality is difficult, lengthy, and requires the support of politicians and other interest groups, but improving corporate governance on a firm-level is a feasible goal. The results suggest that even prior to legal and judicial reform; firms can still reduce their cost of capital by establishing credible investor protection provisions. So, the firms in countries with poor investor protection can use provisions in their charters to improve their corporate governance, which may improve their performance and valuation. However, the task of reforming the legal systems should remain a priority on the policymakers agenda.

2.2 Mergers & Takeovers Trend

It is logical to say that, the impact of any merger or takeover should get translated into human terms down the line. Mergers and acquisitions bring the problems of cultural integration of two entirely disparate organizations, each with its own unique history, and structure. The growth in number of M & As, has acquired even greater managerial importance. Between 1988 and 1992, the number of M&As in India grew from 15 to 30. By 1994 this number had increased to 150. In 1996 approximately 450 mergers and acquisitions took place.13 Growth rates for Mergers & Acquisitions Year # Mergers & Acquisitions Growth Rate 1988 15 ---------1992 30 100% 1994 150 500% 1996 450 300% Corporate mergers and acquisitions, almost universally accompany changes in the managerial structure and systems: key personnel are replaced; new, and more stringent, reporting and control procedures come into force. A transfer of ownership calls for changes in the performance criteria, reporting procedures and control mechanisms. Even though such changes are based on sound business logic, they are usually imposed, and, hence, alienate people. The feelings which mergers and takeovers arouse
13

Dr.Madhukar Shukla, Humanising corporate Takeovers , Business Line 1997.

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among the employees are very much evident form common post-M&A symptoms, e.g., increase in executive turnover, breakdown of lines of communication and control, resistance among executive to implement changes, etc. Colleagues well integrated in team work for many years either leave or are transferred to other parts of the organization. For instance, after the merger of Warner Hindustan and Parke Davis in 1988, almost 30 top executives left within a period of two years. Similarly, in the HLLTomco merger, about 55 key Tomco executives left the company within a year or so. Such fear in post merger (or acquisition) era leads to management resistance or entrenchment strategies in takeover process. Insufficient disclosure by management may also be result of such fear.

2.2.1 Market for Corporate Control before Liberalization

Prior to 1991, mergers and acquisitions were restricted under Indian law, in terms of industrial licensing laws and restrictive statutory provisions. In fact, business houses like the Goenka Group, or the Manu Chhabria Group grew largely through acquisitions; earlier on some business houses such as Bangur Group grew mainly by taking over Erstwhile Anglo-Indian firms (Bagchi (1999:58)). Mergers and takeover activities continued to take place during 80s. Both friendly TO bids on negotiated basis and a few hostile bids through hectic buying of equity shares of selected companies from stock market have been reported frequently.

2.2.2 Regulations before Liberalization Era:

Clause 40 was incorporated in the listing agreement that provided for making a public offer to the shareholders of a company by any person who sought to acquire 25% or more of voting rights of a company. The scope of hostile TOs (as against friendly TOs) was limited prior to 1991. The company board can refuse to transfer shares on two grounds:

1- The transfer was against the interests of the company 2Against the public interests

Prior to 1991, an open offer was mandatory for acquiring 25% stake in company. In liberalization process this limit was reduced to 10% to make market for corporate control more transparent.

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2.2.3 Regulations in Post Liberalization Era:

Under new regulations, the need for prior approval of central government for merger and acquisition activities was abolished. This has led to rise in number of mergers and TOs. The given table shows the number & percentage change in number of mergers and TO activities in India from 1988-98. It also includes the realized as well as abortive bids. Sharp rise in merger and acquisition activities is evident from table figures. There were 58 mergers and TO from 1988-90, it rose to 71 in 1991 and 730 in 1998. There was a sharp rise in number of merger and TO activities during 1988-93. The average rate of increase was around 89% for the five year period. Since then the growth rate had maintained an average of 20.5%.

Merger & Takeover Announcements from 1988 to 1998 (India)

Year
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Number % Change
15 18 25 71 135 288 363 430 541 636 730 20 38.9 184 90.1 113.3 26 18.5 25.8 17.6 14.8

Source: Collected from various Business dailies (Newspapers), various issues and Monthly Review of the Indian Economy (CMIE bulletin).

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SEBI took over the function of the controller of Capital Issues (CCI) in 1992. The regulations on mergers and TOs were modeled closely along the lines of the UK city code of TOs and mergers. The SEBI regulations have borrowed substantial concepts from UK code, e-g the compulsory requirement of making a public offer on acquisition of particular level of share (ownership). (Thakur (1996). To handle the complexity of TO market a committee chaired by justice P.N Bhagwati in November 1995 to review the existing regulations. Under the revised code the acquirer is asked to make a public offer for a minimum of 20% capital as soon as 10% ownership and management control has been acquired. In order to ensure compliance of public offers, the acquirers are required to deposit 50 % of the value of offer in an account. Furthermore, the acquirer has to disclose the sources of funds. In October 1998, the threshold limit was raised from 10% to 15% (OR raised from 2% p.a for creeping acquisition to 5% p.a.). Current regulations on making disclosures of substantial acquisitions mandatory ensure that the equity of firm doesnt covertly change hands between acquirer and promoters. Under section250 and 409 of companies act, target companies can shelter against raiders if the proposed transfer prejudicially affects the interests of the company. The takeover defense mechanism as poison pills for incumbent management as in US &UK are not allowed under current regulations. The main objective of regulations governing TOs is to provide greater transparency in the acquisition of shares, and change of ownership control, through a system based on fair disclosure of information. The regulations seem to have taken a liberal view towards TO, as they are thought to play an important role in building corporate synergy, in raising shareholder value and keeping companies on their toes. CII (Confederation of Indian Industry) report on CG claims that TO are internationally experienced to aid the growth of industry and businesses, by creating economies of scale and scope, imposing a credible threat on management to perform for enhancing shareholders value.

2.2.4 Recent Evidence on Ownership Structure

Every major corporate group in India had a closely held company or partnership called a managing
agency. In fact, they functioned like holding companies. Managing agencies would float companies, and their official permission ensured massive over-subscription of shares. Given excess demand, most of these companies could split shareholdings into small enough allotments to ensure that nobody barring the managing agency had sufficiently large stocks to ensure their presence in the board of directors. Thus, dispersed ownership allowed managing agencies to retain corporate control with relatively low equity ownership a trend that continued right up to the mid-1980s and early 1990s. 27

The tendency of management in India to enjoy control rights that are disproportionately greater than its residual cash flow rights goes back to the early years of the 20th century. Since, much of corporate growth in pre-independent India was financed through equity; Indias urban investors developed a sophisticated equity culture by the mid-20th century. In some industries, Indian merchants who were long term corporate vendors or purchasers also happened to be stockholders. Given the simple and basic nature of technology and low barriers to entry, some of these traders began to accumulate shares in the secondary market and then demand seats on the boards. This happened in a significant way in the jute and coal industry even during the colonial era. Goswami (1985, 1988, 1990). It would be fair to say that low equity ownership coupled with complex crossholdings, allowed most promoters to control listed companies with relatively low ownership. Moreover, the banking sector was surprisingly well developed for a country as poor as India. Every major bank that exists in India today was in operation well before independence. They were privately owned. The law which regulates stock exchanges and the transactions of securities, The Securities Contracts (Regulation) Act, was passed in 1956. Thus, India in 1947 had a sizeable corporate sector accounting for at least 10% of GDP; it had well functioning stock markets and a developed banking system; it had a substantial body of laws relating to the conduct of companies, banks, stock markets, trusts and securities; and it had an equity culture among the a section of the urban population. It was probably the de-colonized country that was best equipped to practice good corporate governance, maximize long term corporate and protect stakeholder rights. But it didnt. To understand why and how India squandered its early advantages, it is necessary to examine the post-independent regulatory regime. The first barrier to investments came with the Industries (Development and Regulation) Act, 1951 (IDRA), which required all existing and proposed industrial units to obtain licenses from the central government. Entrepreneurial families and business houses that had built their fortune in textile, coal, iron and steel and jute now used licenses to secure monopolistic and oligopolistic privileges in new industries such as aluminum, paper, cement and engineering. Over the years, licensing became increasingly stringent and was accompanied by multiple procedures that required clearances from a large number of uncoordinated ministries. In 1956, when the Industrial Policy Resolution (IPR) adopted a socialist pattern of society and prescribed that the public sector would occupy the commanding heights of the economy. So, India succeeded in creating another barrier to private investment. The widespread nationalization began in 1969 with the insurance companies and banks followed by petroleum companies and collieries in 1970. In early 1980s successive governments taking over financially distressed private sector textile mills and engineering companies. 28

2.2.5 Strands to the Corporate Misgovernance

The excess leveraging and role of Development Financial Institutions (DFIs) as a shareholders caused Misgovernance in Indian corporate sector. By the early 1980s, Long (many) term loans for industrial projects were sanctioned with a long term debt-to-equity ratio that exceeded 2.5:1, and a total debt-toequity ratio that went over 4:1. This kind of gearing allowed the promoters to start projects with a relatively low equity base. In fact, their equity contribution was still lower. During the industrial expansion of the 70s and 80s, the average share ownership of the controlling groups was 15%.In other words, it was possible to embark on a Rs.500 million project with only Rs.100 million of equity, of which a mere Rs.15 million came from the promoters for control. To understand the extent of leveraging, one needs to take a look at corporate data for the financial year ended March 1991 just before the beginning of economic reforms. In that year, 528 listed manufacturing and non-banking services companies posted sales in excess of Rs.500 million. Some 65% of their total capital employed of Rs.1145 billion (or $64 billion at the prevailing exchange rate) accounted for by borrowed funds. Almost 20% of borrowings were supplied by the three all-India DFIs. The mean gearing (ratio of total borrowing to net worth) was 1.25, the median was 1.44 and one third of the sample were leveraged in excess of 2.50. The other aspect of poor governance had much to do with the shareholding of government owned financial institutions. Even today, years after the advent of economic liberalization, a substantial proportion of the equity of Indias private sector companies is held by the DFIs (Nationalized insurance companies, Government owned mutual fund, the (UTI) Unit Trust of India.

2.2.6 Government still owns Big Stake

Chart A plots a scatter of Indias top 397 listed companies, ranked according to market capitalization. The mean shareholding of state-owned financial institutions is 20.1% and median is 19.6%. This kind of indirect state ownership of equity also fostered poor CG through inefficient monitoring. The institutional shareholders insisted on nominating their directors on boards. Given their shareholdings, nobody could argue with that. However, at best, most of these nominee directors were incompetent; at worst, they were instructed to support the incumbent management irrespective of performance.

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Much of it has to do with state ownership of these financial institutions, where nobody was rewarded for profit-making or punished for adverse wealth and income consequences of inaction. Thus, the institutional share-owners, who could have played an important governance role, chose not to do so. Their control rights vastly exceeded their cash flow rights. DFIs were very well placed to play the role of CG watchdogs in the 70s and 80s. They were like the large German Hausbanks being major lenders and substantial shareholders. On the one hand, the country had laws that regulated companies and protected shareholders rights, and had a very large and active industrial sector ranging from complex petrochemicals to simple toy manufacturing. On the other hand, a combination of licensing, protection, quotas, high gearing and poor board-level accountability had created an environment that didnt punish poor corporate governance.

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2.2.7 Structure of Corporate India

Consider the top 100 companies ranked according to market capitalization as on 1 April 1991 Seven of the top 10 companies ranked by market cap as on 28 February 2000 either did not exist or were not listed on any stock exchange.14 The dominant characteristic of todays top 50 companies is the preponderance of professionally run businesses. In 1991, 22 out of the top 50 companies were controlled by family groups that held their control during the license-control regime. By February 2000, the roles were reversed: 35 were professionally managed, of which 14 were first generation businesses; only 4 out of the 50 were run by older business families. The new breed of managers believes in professionalism and running business transparently to increase corporate value. Thus, the need for good CG is being appreciated as a sound business strategy, to tap domestic as well as international capital. Indian corporate sector consists of closely held (private limited) as well as publicly held (public limited) companies.15 Among the latter are those which are listed in one or more stock exchanges. Table 1 gives the data for 1997-99.

14

Among these are Infosys (ranked third with a market cap of almost $14 billion and the first company to be listed on Nasdaq), Zee Telefilms (ranked fourth with a market value of $13 billion), and Reliance Petroleum (which is putting up Asias largest refinery in Jamnagar in Gujarat, and has a market cap in excess of $7 billion).
15

There is no category called listed company in The Companies Act, 1956. That is defined in the Securities Contract (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992.

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The expected number of closely held companies vastly outnumbers the publicly held ones, and constitutes the bulk of small scale enterprises. However, the public limited companies including the listed ones which account for almost two-thirds of the book-value of equity. The other point worth noting from Table 1 is the size of the government corporate sector: while it accounts for a mere 0.24% of the number of companies, it speaks for 39% of corporate Indias paid-up capital.

Although widely held firms speak for only 14% of the number of registered companies, these account for 66% of corporate Indias book value of paid-up capital. The government sector plays a significant part among the widely held (though not necessarily listed) public limited companies. While government companies constitute only 0.3% of the number of companies, these account for 39% of paid-up capital. There are over 10,000 listed companies, the more reputable of which are listed on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). As of February17 2000, the market capitalization of the BSE stood at $236 billion making it the seventh largest exchange in AsiaPacific, and accounting for 53% of Indias GDP. Private sector listed companies account for almost 80% of BSEs market capitalization and the remaining 20% is made up of listed government companies. Listed companies represent all possible commercial activity, covering every major branch of manufacturing and services.

As in most stock exchanges, a large number of companies constitute a very small proportion of the market cap, while relatively few make up for the bulk. For instance, the top 10% of private sector companies (450 firms) account for over 96% of private sectors market capitalization. Freely tradable shares account for roughly 30% of the equity of listed companies. However, even on very active days, no more than 20% of this stock is traded and that estimate is on the high side. Thus, despite the size of corporate Indias market capitalization, trading volumes are quite thin. That has implications for the future of takeovers through open offers.

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It is fair to say that any company worth its reputation in corporate India is listed in either BSE or NSE, or both. Moreover, the present level of market capitalization ranks India as the seventh in Asia-Pacific league table. Table 2 gives the comparative market capitalization rankings. A remarkable feature of listed Indian companies is the relative size of the Stat Owned Enterprises (SOEs). For example, the BSE lists only 73 government companies which accounts for less than 2% of the listing. Yet, these stocks account for almost 15% of market capitalization. The representative listed SOE is larger than its private sector counterpart. Public shareholding ought to cover shares owned by individual investors, mutual funds, insurance companies and DFIs. In India, it would be wrong to consider this aggregate as a measure of freely traded shares. DFIs and, nationalized insurance companies hardly trade in the market. Hence, a more realistic concept of freely tradable shares should be limited to the holdings of Individual investors and the mutual funds.

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This share varies considerably across listed companies, as Chart B shows. Thirty percent of the shares of a typical listed company can be theoretically treated as freely tradable. The average trading volume is far less. For liquid, pivotal stocks, no more than 20% of the freely tradable shares are actually traded on active days.

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2.2.8 Stat Owned Enterprises

State owned enterprises (SOEs) among listed companies, account for 20% of market capitalization it necessary to touch upon their governance structures. These companies can be best described as: Agents without principals. Shareholders (or principals) of private sector companies are direct beneficiaries of profitable performance. Therefore, in theory, they have an incentive to monitor management so that it maximizes corporate value. In contrast, most government companies, especially the unlisted ones, do not have a substantial body of informed private shareholders whose income depends upon the performance of these companies. The governments and their agents are process oriented, whereas firms have to be result oriented. The mismatch arises by aversion to risk taking. When a civil servant serves on the board of a SOE, he typically ensures that it follows proper procedures, and avoids any risky decision that may have harmful consequences for his ministry. Thus, important organizational changes are not made, staff remain undisciplined, loss-making plants are neither downsized nor closed, wages are not linked to productivity, and redundant workers are not retrenched. Since most SOEs have more than 50% government ownership, they fall under the control of the State. This has affected SOEs in several adverse ways. All SOEs are expected to achieve a wide variety of non-commercial objectives which are imposed by the ministries and the Parliament. One of the most difficult one to maintain is employment reservation16. Every SOE must ensure that the share of employment under reserved categories (castes, tribes, other backward classes, physically handicapped persons, and ex-military or dependants of those killed in military or paramilitary action). State status limits managers from downsizing plants, retrenching or re-deploying employees. Finally, the directors of SOEs have little autonomy in finalizing investment decisions. What do SOE managers have to say about these restrictions? A Standing Committee on Public Enterprises (SCOPE) survey published in 1997 emphasizes their frustrations in no uncertain terms, as can be seen in Table.
16

Presently, the minimal reservation quotas are 15% for Castes, 7.5% for Tribes, and 27% for Other Backward Classes making it 49.5% of total employment. For the relatively lower paid, lower skill jobs, there is an additional quota of 3% for the physically disabled, and 14.5% to 24.5% for ex-military and dependants of those killed in military or Para-military action. These quotas are particularly restrictive in selecting people for technically specialized jobs.

35

The SCOPE Survey --- The Response of Senior SOE Managers

There can be no real solution to SOEs without systematic and transparent privatization. This has been recognized by the present government and clearly observed in its policies. However, progress has been poor partly because of resistance from entrenched, rent-seeking bureaucracy, and partly due to the lack of sufficient political will. Even the better run SOEs are suffering on two counts. First, there has been a major fall in corporate value (EVA). For the four year period (1995 -1998), sample of 109 SOEs in aggregate lost EVA worth Rs.9.1 billion, which amounted to almost 9% of their capital employed.17 Second, there has been a far more important loss that of skilled and trained managers leaving for the private sector.

17

Bhandari and Goswami (2000), Chapter 3.

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3. Family Ownership
60% to 70% of all US small businesses define themselves as family owned18. Family owned means also Family operated. The younger generation individual who join the family business, runs the risk of becoming a permanent person-in-waiting as owner-founder, may want to prove that no one can fill his/her shoes. Some economic development economists believe that dominance of family in the ownership structure is a major barrier to entrepreneurial activity. Family Ownership diminishes the incentive to achieve, discourage risk taking, and slows down the progress of capital mobilization.19 The revenues from investment might be subject to family sharing rather than reinvesting. One might say that reinvestment rate is low as compared to non-family ownership. The family may help to obtain access to supplier, merchant, creditors, market authorities, local officials, and people with economic power and influence. It could be helpful when extension of credit is badly needed, when family guarantees the payment. Conflict could also arise when relatives look at the business from different perspectives. Active partners (engaged in daily operations) of family may like to conserve their salary to retain capital for reinvestment and future growth. Conversely, silent partners (Not engaged in daily operations), may prefer to receive high level of payout in form of dividends. Other conflicts are generated when favorite children of family are promoted to executive positions ahead of others. This problem might lead to division of business. Similar patterns in family firms recur frequently across a wide variety of circumstances and demographic changes.

3.1 Advantages:
Family ownership can have the following advantages to the enterprise: 1234567818

Long term orientation Less pressure from stock market Less takeover risk Greater independence of actions Strong commitment Motivation Continuity in leadership Willing to plowback profits

Arthur Andersen Enterprise Group and National Small Business United, Survey result of small and middle market business, (July 1992) 19 Strategic entrepreneurial Growth, family based succession, D. F. Kuratko & H. P. welsh, 2001

37

9-

Quick decision making

10- More flexible 11- Early training of family members

3.2 Disadvantages:
Dominance of family can possibly have following disadvantages to the enterprise: 1- Less access to capital market and may curtail growth 2- Messy structure, no clear division of tasks 3- Tolerance of family members as managers 4- Inequitable reward system 5- Family disputes overflow into business (see 3.15) 6- Resistance to change, Secrecy of matters 7- Family members milking the business 8- Disequilibrium between contribution and compensation. As compared to large corporations, family firms can afford more flexibility, control, compatibility, trust, and opportunity. A sense of trust has the potential to make family partners more secure, more open, and more informed than any team of unrelated persons could be. According to Peter Davis 20 a Family ownership can have positive effects on the operations of a business on following ways: Family business can easily demonstrate high levels of concern and caring for individuals, than

are found in typical corporations. Family business can take long term view more easily than corporate mangers that are being

judged on year to year results. Family businesses have maintained a long tradition of providing quality and value to customers.

3.3 Problems
When close relatives, work together, social and emotional variables often interfere with business decisions, sometimes ultimately having serious, or even fatal, consequences for family business. As the partners in family business grow older, they may develop a tendency to avoid risk. With this attitude they may and often do block the growth in their familys business.

20

Peter Davis Realizing the potential of the family business, Organizational dynamics, 1983

38

A family business owner believes that he is indispensable to the success of business, and must have say in every phase of business, often denying well educated or well trained children or key employees, the opportunity to demonstrate their competence. Yet, the owner is aging and his decision making competence is diminishing in highly dynamic environment. The average life expectancy of a family business is 24 years --- interestingly, the average tenure for the founder of business.21 Family businesses have been in existence for a long time, and they will undoubtedly continue to survive, split, merge, and continue in new vein in future. The ownership style might change with the requirements of external environment.

3.4 Problems with Family-owned Businesses in India

Why do only 3 percent of Indian family-owned businesses survived the third generation (Confederation of Indian Industry): Bad management practices. Lack of planning for succession. The lack of marketing for competition purposes. Efficiency of the corporate resources. Globalization. The above given problems support the concept of diverse ownership for the long term survival of corporations. The diverse ownership brings the capabilities, to handle bad management, proper planning, marketing skills and efficient use of corporate resources.

3.5 Cross Holdings

Traditional family dominated business groups which constitute a sizeable chunk of listed companies 22 have tended to protect their interest through complex cross-holdings. Contrary to popular opinion, the main objective of this practice was not to prevent takeover bids, but to avoid steep wealth and inheritance taxes that characterized pre-1991 India. Abolition of both these taxes as well as the tax on individuals for dividend income, and a reduction of personal income tax rates to a little over 30%, has led to many business groups slowly unwinding their cross-holdings. The process of moving towards cleaner and more transparent share ownership is also driven by an increasingly active stock
21

Richard B. & W Gibb Dyer, Managing continuity in the family-owned business Organizational Dynamics, 1983, (7-8) 22 Omkar Goswami, The Tide Rises, Gradually Corporate Governance in India, OECD Center, April 2001.

39

market. Foreign institutional investors, who now account for anywhere between 24% and 30% of the equity of highly traded companies, avoid companies with complex cross-holdings. Desire to raise market capitalization and to access international capital are finally doing the right things for the pattern of equity-holdings.

3.6 Family-owned Business (India)

We will try to elaborate how family ownership evolved through the history, succession process, and future of Family-Owned Businesses in India.A family-owned business in India can be defined as a business governed and/or managed on a sustainable potentially cross generational basis, to shape and perhaps pure the formal or implicit vision of the business held by members of the same family or a small number of families (Chua, Chrisman, and Sharma, 1999).

Indian Family-Owned Business Contributes 75 percent to the employment of Indian citizens, makes up 65 percent of Indias Gross Domestic Product (GDP), and 71 percent of Indias market capitalization is contributed by family-run enterprises (Sep 17, 2001. Business Line). In 1991, 22 out of the top 50 companies were controlled by family groups. By February 2000, 35 companies were professionally managed, of which 14 were first generation businesses; only 4 out of 50 were run by old business families.

3.7 A Look in to the History

In the beginning markets were small and highly entrepreneurial and a businessman would enter another market as growth flattened in a particular business or segment. The view of the Indian Government towards business was big is bad. For example, in 1969 the TATA one of the first family businesses had 70 companies and the BIRLAS had 203 companies that they controlled (Government of India, 1969).

3.8 Family Business Successors

A son in the family is the most likely candidate to take over the reins after the father decides his son is ready for the task. A father handing down his responsibilities to his son is a transition that gains great 40

pleasure for his self and much respect from other family members and society. Some successors are sent abroad to study for technical and managerial training, so they could take over without any grooming.

3.9 Characteristics of a Successor

The most important attribute for family-owned business successors is the ability to manage the finances of the company. The most important personality traits are: Enthusiasm; creativity; independence; integrity; intelligence; self-confidence; a willingness to take risk; to have respect for seniors; and To work for the collective rather than the individual good. (Dutta, 1997)

3.10 Responsibilities of a Successor

It is understood that they still have to take responsibility for their parents, unmarried sisters, aunts, and younger siblings. A characteristic that a father son relationship has is the obedience that the son does not question his father in public. This is a sign of respect that is carried by the son since birth (Dutta, 1997).

3.11 The Influence of Families on its Successors

A survey called the PRIMA (People and Responsibility Issues in Management) showed results of the Indian influence on its successors. It shows that 64 percent of Indian family-owned businesses expected their children to join their business compared to US family businesses which were estimated at 90 percent (2003, Jacob). Another Indian statistic shows that 29 percent of Indian family businesses intend for their children to start in the business at an early age. When compared to other countries this number is far lower than the average mean of 37 percent (2003, Jacob). They have enough professional experience before they go abroad for technical and managerial training.

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3.12 The Largest Family-owned Businesses in India

Reliance Industries- The founder was Dhirubhai H. Ambani, and is located in Mumbai, ranked 63rd wealthiest family-owned business in the World with an estimated value of $9.634 billion. TATA Group-Industries-The founder was Jamsetji Tata, and is located in Mumbai is ranked 71st wealthiest family-owned business in the World with an estimated value of $7.959 billion. Aditya Birla Group-Industries-The founder was Ghanshyamdas Birla, and is located in Birla is ranked 87th wealthiest family-owned business in the World with an estimated value of $6 billion.

3.13 What Indian Family-owned businesses have to do to compete in the Future?

Make sound business decisions. Deal with the complexities of both family and business realities. Must embrace what is best for the family business. Attract and retain good professionals. Plan for business succession and estate planning. Train family members and non-family members. Respond to globalization and entry of multinationals. Must learn how to succeed in a free market economy. In view of family based firms in emerging markets in general, and India in particular the Owner managers have a strong incentive to manage their companies well and generate wealth as their fortunes are tied to the well being of the company. They are promoters of the company and have the greatest stakes (in tangible as well as in intangible terms) in the success and failure of their companies.

3.14 Mukesh Ambani admits to differences with Anil

Reliance Industries Chairman Mukesh Ambani said that his remarks on the ownership issues was torn out of context and Dhirubhai Ambani has settled all ownership issues pertaining to RIL within his lifetime. The rumors about the Ambani brothers splitting up, got a new lease of life when Reliance Group Chairman Mukesh Ambani admitted to having differences with his brother Anil over 'ownership issues.' He, however, said that the differences are in the private domain.

42

He said that Reliance is one of the strongest professionally-managed companies and the investors in his company had no reason to worry, as the issues will have no bearing on the functioning of the Group. Citing an example of General Electric Company, he said like GE has moved beyond Jack Welch, the legendary former CEO of the company, Reliance has also moved beyond one, two or three individuals. According to the Centre for Monitoring Indian Economy, the promoters (Ambanis) hold 46.67 per cent of the stake in Reliance Industries Ltd, 13.48% is held by the public and foreign institutional investors own 22.85 per cent equity. Reliance is India's largest private company with an annual turnover of about Rs 80,000 Crore 23 (Rs 800 billion) and has presence in various sectors including oil refinery, petrochemicals, power and telecommunication.24

3.15 Conclusion
Indian people have proven that they are self-reliant, fearless, and confident in their abilities. The decisions that they make in their businesses will have a strong effect into the future. It is no secret Indian people take their time in making decisions, but these decisions that they will make in the 20th century will have a large impact on their future and the future of their families.

23

24

1Crore = 10 millions

Source:

Daily Business,

November 18, 2004

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4. Domestic vs. Foreign Ownership

In India, until the start of the liberalization process in 1991, the monitoring of corporations was severely constrained on account of a host of factors. Firstly, there were legal restrictions on the acquisition and transfer of shares. Domestic financial institutions remained passive and often sided with the management. Secondly, many Indian corporations were managed by family members. Professional managers appointed at the top level of corporate hierarchy were the exception rather than the norm. This blunted (pressed) the effectiveness of the managerial labor market. Thirdly, the domestic market in India was shielded from competition in the product market by tariff barriers and other regulations. The cumulative effect of all these factors was that managers of Indian firms remained entrenched with hardly any accountability on their performance. The post 1991 time-period marked a dramatic shift in the institutional framework in India. A takeover code was adopted in 1994 made the way for basic market for corporate control. Foreign capital (both direct investment as well as institutional/portfolio investment) leapfrogged from small levels to form a substantial component of the countrys total capital inflows. 25 The investment limit though, especially with regard to foreign institutional investment, remained relatively restrictive. For example, in 2000, the shareholding of an individual foreign institutional investor is limited at 10 percent of the total issued capital in a firm with a cumulative foreign institutional investment limit of 24 percent.

Another distinctive feature of the Indian corporate landscape is the prevalence of business groups. Although there is no legal definition of a group, firms are usually classified as belonging to a group when there is common ownership and management by family members. It is relatively easy to identify group affiliation with a high level of accuracy because the information pertaining to group affiliation is publicly disclosed. Moreover, firms are usually members of only one group and do not change their group affiliation over time. Each group has a controlling family that sets the overall strategic direction of the firm and regulates all financial transfers. Every firm within a group has a separate legal entity and can be listed separately on the stock exchange. Each firm has its own unique set of shareholders. The total insider shareholdings of a group firm include stakes held by executive/family directors and domestic corporations affiliated with the same group.
The total percentage of foreign direct investment and foreign institutional investment has risen from 1.4 percent of Indias total capital inflows in 1990-91 to 49.7 percent in 1999-00 (Source: Reserve Bank of India Annual Report 2000-01, 25

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4.1 Domestic ownership

In many emerging countries, domestic corporations are among the largest group of block-holders (Claessens et al., 2000). In Indian listed firms, they also constitute the largest category of shareholders. These block-holders usually have a long investment horizon. Allen and Philips (2000) present evidence that supports the argument that corporate ownership provides significant benefits to firms involved in certain business agreements by reducing the costs of monitoring the alliances or ventures between firms and their corporate block-holders. Furthermore, in response to the greater competitive and liberalized environment in India since the mid 1990s, a number of companies have begun the process of acquiring strategic stakes in other companies in an effort to enhance and sustain the domain of their core competence. Thus their monitoring incentives as well as their abilities are substantially greater than those of domestic financial institutions. These domestic corporate holdings thus share the features of concentrated - inside/outside holdings (depending on group affiliation) from an agency perspective and are characterized as strategic - domestic shareholders from a resource based perspective. Provided the institutional context in terms of legal regulations is favorable, the presence of large corporate shareholders also increases the likelihood that a firm is taken over. So, we can say that Domestic corporate ownership provides strong monitoring capability to market for corporate control, and thus positively affects firm performance.

4.2 Domestic Financial Institutions

Domestic financial institutions form a significant block of the total shareholding of Indian firms, and consist of development financial institutions, insurance companies, banks and mutual funds. These financial institutions are predominantly government owned. Government ownership reduces their monitoring potential significantly. Firstly, the Governments nominees on the board are typically bureaucrats with minimal expertise in corporate matters. This fits in with the characteristics of financial - domestic shareholders from the resource-based perspective. Secondly, even if these Government agents are equipped for the task of oversight in corporate matters they do not have a strong incentive to be effective monitors as their tenure and career prospects are rarely affected by the performance of the companies in which they serve on the board as nominees. Moreover, as many of the prominent business families have links with the political elite who have substantial influence over the functioning of these government owned institutions, the nominees tend to side with the management. These are the agency costs associated with a lack of incentive alignment and are a feature of dispersed inside holdings. 45

Thirdly, since governments especially in developing economies, support significant social welfare objectives, they are less profit driven and hence less vigilant in their monitoring role (Ramaswamy et al., 2002). Due to the complex links between the business families and the ruling elite, these government controlled financial institutions are forced to purchase stocks of under performing firms to bail them out in times of financial crisis. This demonstrates how the institutional context influences the behavior of these shareholders. Combining the agency, resource-based and institutional perspectives results in strong negative affects of Domestic financial institutional ownership on firm performance.

4.3 Domestic ownership and Group affiliation

Business groups consist of a collection of firms, which are linked together by common ownership, and director interlocks. Group affiliation has both benefits and costs. Among the beneficial effects, Chang and Hong (2000) find that group companies serve as an organizational structure for appropriating quasi rents, which accrue from access to scarce and imperfectly marketed inputs such as capital and information. Khanna and Rivkin (2001) report that groups can boost the profitability of member firms as they fill the voids left by the missing institutions that normally underpin the efficient functioning of product, capital and labor markets. However, groups are also associated with the larger possibility of (i) inefficient transfer of resources from more profitable firms to financially constrained firms (Shin and Park, 1999) and (ii) exploitation of minority shareholders by means of tunneling of resources through pyramids and extensive crossholdings by the controlling family (Johnson et al., 2000, Bertrand et al., 2002).26 In many Indian business groups, domestic corporate holding is used primarily as a mechanism to expropriate wealth of other minority shareholders. These shareholdings serve as the primary vehicle to tunnel resources at the expense of minority shareholders and facilitate intra-group resource transfers. The controlling shareholders therefore use these shareholdings to further their own interests. In such a scenario, domestic corporate holding affiliated to a group would mitigate the monitoring efforts of other shareholders and would encourage controlling shareholders in their efforts to exercise private benefits of control. This is consistent with the characteristic of these shareholders being concentrated inside shareholdings as viewed from agency theory. While resource - based theory suggests that these

Bebchuk et al. (2000) describe the means by which pyramids and cross holding structures enable one shareholder to maintain complete control of a firm while holding less than a majority of the cash flow rights

26

46

shareholders posses traits of being strategic domestic shareholders, being inside shareholders, they lack the positive reinforcing effects which non-group domestic corporate holdings possess Consequently, we expect that Domestic corporate ownership in group firms will result in lower firm performance than domestic corporate ownership in non-group firms. Owner managers belonging to group companies can also exert a negative influence. Their stock holdings can mitigate monitoring efforts by other shareholders because in group firms domestic corporations and group directors could act to expropriate wealth. Owner managers in group-firms may also pursue non-profit maximizing objectives that increase their private benefits. In fact, owner managers among group firms are generally endowed with greater levels of resource rich features such as board capital (human and relational) as viewed from a resource-based perspective vis vis non-group firms (being strategic domestic shareholders), in a weak institutional setting these positive effects are reduced by the higher agency costs (due to greater levels of principal principal goal incongruence) associated with owner managers belonging to groups. We therefore expect that Ownership by owner managers in group firms will result in lower firm performance than ownership by owner managers in non-group firms.

4.4 Foreign ownership

It is important to separate the effects of foreign ownership in a firm belonging to foreign industrial corporations and foreign financial institutions. Agency theory suggests that since foreign corporate ownership stakes are larger and less fragmented than stakes held by foreign institutional shareholders, the incentives of these larger shareholders are more aligned to perform an effective monitoring role. Foreign corporations holding an ownership stake in a domestic company also tend to invest in firms related to their core business. For example, Honda is much more likely to invest in a transport company than in a brewery. Thus, foreign corporations will have relevant experience and know how enabling it to benchmark the performance of an Indian company relative to the performance of other companies in other markets wherein the foreign corporation holds a stake. The nature of such a relationship typically goes beyond financial contributions and extends to provision of managerial expertise and technical collaborations. Companies with foreign corporate shareholdings are endowed with superior technical, organizational and financial resources. For instance, Chibber and Majumdar, (1999) find that the extent of a foreign firms control over a domestic firm is positively associated with the degree of resource commitment to technology transfer. Djankov and Hoekman (2000) find foreign investment to be associated with the provision of generic knowledge (management skills and quality systems) and specific knowledge (which 47

cannot be transferred at arms length). Furthermore, a study conducted by Dhar (1988) on foreign controlled companies in India finds that most of these enterprises have business links beyond mere equity participation. They have technical collaborations, nominations of foreign directors on their boards, consultancy and marketing arrangements, trademarks, patent obligations and managerial resource sharing.3 The sustainability of these advantages though, is often linked to the institutional context. As a consequence of imperfections in capital, labor and technological markets, foreign shareholders are, relative to domestic shareholders, in a better position to exploit their relative advantages to influence firm performance positively (see Chibber and Majumdar, 1999; Khanna and Palepu, 2000a and Sarkar and Sarkar, 2000). Furthermore, countries with stronger shareholder rights and judicial systems and a higher level of economic development attract higher levels of foreign capital (Aggrarwal et al., 2003). Governments also stimulate investments made by foreign corporations by providing various incentives. These incentives explain how the institutional context can influence the firms ownership structure and the provision of specialized resources. We can characterize these foreign corporate holdings as concentrated -outside and strategic foreign. These perspectives lead to a strong positive influence on firm performance:

4.5 Positive Effects of Foreign Corporate Ownership

Foreign financial institutional investors can behave in a manner that is significantly different from foreign corporate investors. In the case of foreign financial institutions, decisions to buy and sell shares of domestic firms are made by fund managers, whose performance is measured by comparing their results with a stock market index and/or with competing institutions of a similar class. These institutions have different investment horizons and are primarily oriented towards stock market based measures of performance. They have incentives to sell their stakes in a firm unable to maintain short-term capital gains. Foreign fund managers also manage a portfolio of a large number of investments in different industries to obtain the benefits associated with a diversified portfolio of investments. Furthermore, the ownership stake of a single foreign institutional investor as well as foreign institutional investors as a group (class) in a single Indian firm is legally constrained. Consequently, they hold extremely fragmented stakes. These shareholders are thus representative of the dispersed outside category of shareholders as viewed from an agency perspective. Foreign institutional investors, each holding only very small stakes, are unlikely to act as a cohesive block in enhancing corporate 48

performance. Moreover, they tend to select investments in companies, which are large, familiar and actively traded (Kang and Stulz, 1997), and which are covered by mass media (Falkenstein, 1996). If foreign institutional investors are dissatisfied with a companys performance they have the relatively easy option to sell their ownership stake. As a result, the foreign fund manager is much more likely to sell the shares of an under performing company than to invest time and energy to institute a process of corporate restructuring. These features support that foreign financial institutional ownership is positively associated with stock market-based measures of firm performance only.

In a study on institutional investors in India, Mohanty (2003) states that one of the fund managers told him that what matters to me is the money that I can make from the company and not the governance structure in the company. ....If I am making money I am happy with it. Mohanty further states that two fund mangers told me that if we look at corporate governance alone, then the value of our portfolio might fall Furthermore, according to him, the fund managers have a performance evaluation system, which is entirely based on the performance of the funds they create and manage. Hence if a company with a poor corporate governance record is expected to give a higher return, then the fund manager can very well invest there. In his empirical analysis, he finds that institutional investors have invested in companies with good governance records but he does not find any effect of the ownership stake of these investors on the governance of these companies.

4.6 Foreign Corporate involvement in India

Hero Honda Ltd. is a company promoted and managed by the Munjal family (Hero Group) in which Honda Motors, Japan has an equity stake of 26%. The companys board composition is such that it has four directors who are nominated by Honda Motors; two of these directors hold executive positions having designations such as joint managing director and whole time director. These directors are actively involved in the day-to-day management of the affairs of the company. This is an indicator of the level of managerial involvement and transfer of valuable expertise. With regard to technological collaboration, the company states that Honda Motors is actively involved in the introduction of new products and that they have access to Hondas technology and product portfolio. (Hero Honda Ltd., Annual Report, 2002-03)

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Tata-Honeywell Ltd. is a Tata Group company in which Honeywell Inc., U.S.A (through Honeywell Asia Pacific Inc.) has a 41% equity stake. Both the Tatas and Honeywell nominate three directors apiece. One of the Honeywell directors serves on the board as company vice-chairman and all three directors serve aboard various board level committees such as the Audit, Remuneration and Shareholder grievance committees. (Tata Honeywell Ltd., Annual Report, 2001-02)

Esab India Ltd. is a non-group company in which Esab AB, Sweden and its associated companies (through Esab Holdings Ltd) has a 37% equity stake. The company manufactures welding and cutting equipment under technical collaboration from Esab. The profile of one of Esabs directors states that he is the technical director of Esab AB with responsibility for R & D, quality and environment affairs. Esab and its associated companies worldwide contribute three directors to Esab Indias board and its nominee is the company chairman. The directors serve on the companys Audit and Investor grievance committees as well (Esab India Ltd., Annual Report 2002).

Snowcem India Ltd. is another non-group company having a technical collaboration with George Lillington & Co. Ltd., U.K. for the manufacture of cement specialty products. George Lillington & Co. has an equity stake of 18% in the company and has three directors on the company board (Snowcem India Ltd., Annual Report, 2001-02)

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4.7 Conclusion
The underlying dynamics governing the investments by institutions and corporations are vastly different. Findings (Douma, George, 2003) 27 highlight the fact that the impact of foreign institutional investors on firm performance is not clear-cut. Future studies examining the role of foreign ownership in emerging economies should incorporate this distinction between corporate ownership and institutional ownership. I have provided some benefits of foreign corporate holdings based on their superior monitoring abilities, resource endowments and skills to use the institutional environment to their advantage

Although only a small proportion of Indian firms posses foreign corporate shareholdings, their stakes in individual firms are substantial. While their numbers and holding levels are expected to rise in the foreseeable future. Among the outside domestic shareholders domestic corporations positively influence firm performance than foreign corporations but with different magnitudes. If we assume that domestic corporations hold large blocks of shares, and unlike domestic financial institutions, their monitoring abilities and incentives are substantially superior. Moreover, as firm managements professionalize, travel further along the learning curve and spill over effects begin to manifest, the quality of the monitoring effort may increase.

However, there is evidence to suggest that these benefits could be eroded if these domestic corporations belong to the same group. In the longer term as the government progressively reduces control over domestic financial institutions, Indian private institutional investors could gain in prominence and skill. Under these circumstances, there could possibly be a reversal of some of the negative influence reported by earlier studies with regard to domestic financial institutions.

27

Foreign &Domestic Ownership, Business Groups & Firm Performance, Sytse Douma, & Rejie George, Tilburg University and Cochin University, 2003)

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5. Role of Governance Principles

5.1 - Families, Corporations and other Block-holders
Concentrated Ownership plays a predominant role in the way firms are governed. Controlling owners are the center of gravity of these systems; high in stability and long-term commitment, but low in flexibility and the capacity to attract outside investment. The Governance principles play their role to reduce the concentration of powers in corporate decision making, and help to shape optimum corporate ownership structure.

5.2 Management
The Corporate Governance discussion started along the lines of the Berle and Means (1932) paradigm of large corporations with their share ownership dispersed among small share-holders, and effectively run by their management. Management in turn is seen to hold enormous power because of the high monitoring costs and free rider problems encountered by the share-holders/principals. Effective control by managers allows them to pursue their own opportunistic goals instead of maximizing the present value of the firm to its share-holders. It is well known that the managerial behavior is affected by the management in the current period, however, there could be an effect of managerial behavior on firm performance in future periods also (see Short et. al 2002; for more detailed analysis).

5.3 - Financial Institutions

Market developments are obliging financial institutions to adapt their governance related activities. In this, they try to pursue \arms-length' ' relationship with companies in which they invest, and to defend their interests by selling shares when performance failed to live up to their expectations. Governance principles make the investment policy and involvement of financial institutions in corporate affairs more transparent to other stakeholders.

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5.4 Improving Corporate Disclosure

The topic how companies can improve their disclosures to investors is an important one. From economic perspective, what reward can we give people to do the right thing? This is like a mother saying, that if her child finish his homework before dinner, he can have ice-cream for dessert."28 Cynthia has a different and better way of approaching corporate disclosures (economist's view). She thinks that all the good things can result for the company (its managers and its shareholders), if the company makes full and fair corporate disclosures. It's like everyone getting ice-cream for dessert. In general, management should think more about the market, and less about lawsuits. The focus should be on disclosing information to the market that management thinks is important for shareholders or potential shareholders to know. That information should be honest assessment of the direction and risks that company face. Simply put it as management needs to tell a story. Of course, management should be careful to make its story strictly non-fiction! And the goal should not be to put investors to sleep, but rather to make the information to investors clear and understandable. Management Discussion and Analysis can most effectively explain corporate policy. Management can also tell its story by using clear financial statements and analyses. Financials will be more understandable and compelling if they focus on accounting for the substance of transactions. Principles-based accounting emphasizes the professional judgment of managers and the company's auditors. Of course, management and auditors would need to act with the utmost care and integrity. Practically, neither strictly principles-based nor strictly rules-based accounting is feasible. Ultimately, a hybrid (mix) of rules and principles could be a better choice. This would provide overriding principles that incorporate specific guidelines as examples to give the system more contexts. For now, India still has to work with GAAP. GAAP's complex rules create situations where lawyers and accountants may play games with the rules, rather than focusing on the principles underlying them. The more specific the rules, the easier companies may find it to structure transactions specifically to circumvent them. The impulse is to make sure the line isn't crossed instead of making sure the books reflect the true economic condition of the company. The substance of a transaction should dictate the accounting, not vice-versa.

28

Source: Speech by Cynthia A Glassman SECs Commissioner, at the Northwestern University School of Law, Chicago.

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It is also important to remember that simply complying with GAAP may leave gaps in disclosure and give investors an incomplete or even misleading picture of a company's operations. Similarly, as compliance with GAAP without more information is not a remedy for all of a company's ills, using pro forma, is not necessarily a deadly disease. As long as pro forma is not used in a misleading way, they can be an excellent tool to give investors more information about a company. Another point is that clear disclosure in footnotes or the MD&A (Managements Discussion & Analysis) is important to bridge the gaps between what GAAP allows and the economic reality of the company's operations. Managers should also correct some of the imperfections in GAAP by better disclosure outside the GAAP framework by describing their actions more fully in the company's MD&A. A study by CII (Confederation of Indian Industry) shows that, in the last four years, markets have consistently punished poorly governed under-performers and rewarded the more transparent firms.

5.5 Compliance
The Stock Exchange, Mumbai, 1848 companies were required to comply with the clause 4929 of Listing Agreement, as per the recommendations of Kumar Mangalam Committee Report. All companies are required to submit a quarterly compliance report to the stock exchanges within 15 days from the end of a financial reporting quarter. The amendments also provide for a format for the Quarterly Compliance Report on Corporate Governance. The companies have to submit compliance status on eight sub-clauses: 1. Board of Directors; 2. Audit Committee; 3. Shareholders / Investors Grievance Committee; 4. Remuneration of directors; 5. Board procedures; 6. Management; 7. Shareholders; and 8. Report on Corporate Governance.

29

Deals with corporate Governance compliance, those Indian listed companies are required to fulfill as part of their listing obligations.

54

For the quarter ended September 30, 2002, it was observed that 1,848 and 741 companies were required to comply with the requirements of the Code, for the Mumbai and National Stock Exchanges, respectively. The compliance reports were submitted in respect of 1,026 and 595 companies, for the Mumbai and National Stock Exchanges, respectively. The status of compliance with respect to

provisions of corporate governance analyzed from data submitted by the Mumbai Stock Exchange is set out below.
Board of Directors Audit Committee Shareholders Grievance Committee Remuneration Committee Board procedures Management Shareholders Report on Corporate Governance Total

999

981

1005

677

575

774

998

786

1026

Applicable to 1,848 companies

The impact of these committees is evident in Indian corporate sector. There has been a distinct awareness about the corporate governance issues in India. The annual reports and websites of Indian companies have started providing a large amount of relevant information in time to the stakeholders of the company. The key observations of the consolidated compliance report sent by the Mumbai and National Stock Exchanges are set out below. The compliance level in respect of requirements relating to Board of Directors, Audit Committee,

Shareholders Grievance Committee and Shareholders is very high; Few companies have submitted that the provisions relating to Management and Board Procedures

are not applicable. SEBI has observed that compliance with the requirements of listing agreement is by and large satisfactory, but an analysis disclosed that their quality is not uniform. They also observe that there is considerable variation in the quality of disclosure made by companies in their annual reports.

5.6 Award to Improve Governance Practices

Realizing the significance of efficient financial markets in achieving higher growth rates in economy, The Finance Minister Shri Yashwant Sinha initiated several measures to promote corporate governance among Indian companies and for development of Indian financial markets. While presenting the Budget for 1999-2000, he mentioned It is increasingly being realized that if investors have to be drawn back to 55

the capital market, companies have to put their houses in order by following internationally accepted practices of corporate governance. This is necessary to enhance investor confidence. To promote good governance practices in Indian companies and enhance investors confidence in the market, the Government of India awards the National Award for Excellence in Corporate Governance every year. The Award is recommended by a Panel consisting of eminent persons from financial markets and corporate world. The Ministry of Finance (Department of Economic Affairs) in the Government of India constitutes the panel. Unit Trust of India came forward to sponsor the award. UTI Institute of Capital Markets provides research support to the Panel. S&P carried out a survey of 350 Asian and Latin American companies on 10 points, based on 98 information attributes, grouped into 3 categories: financial transparency and information disclosures; investors relation, and ownership structure; and board and management structure and practices. 19 out of 43 Indian companies managed to get score of 4; INFOSYS scores 7.

5.7 Reward for well Governed Companies

Studies on Indian firms have shown that markets take notice of well governed companies, respond positively, and reward such companies. Such companies have Governance systems in place, which give sufficient freedom to boards for decisions towards the progress of their companies, to innovate, while remaining within a framework of effective accountability. Infosys Technologies won the Golden Peacock Corporate Governance Award 2004. Infosys Technologies Ltd has been voted as having the highest corporate governance score amongst all the Asian large-cap corporations (excluding Japan).30

5.8 Policy Initiatives

The policy formulation for corporate governance should aim at achieving the efficient use of societal resources. The policy makers need to study and assess the governance systems in the corporate sector. International experience (OECD Principles) can also be studied and suitably modified to apply in the Indian corporate sector. The concept of corporate governance has been attracting public attention for quite some time in India. The topic is no longer confined to the halls of universities and is increasingly

30

The Asian Corporate Governance Watch 2004, survey.( September 22, 2004)

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finding acceptance for its relevance and underlying importance in the industry and capital markets. Progressive firms in India have voluntarily put in place systems of good corporate governance. Internationally it has been accepted for a long time. The financial crisis in emerging markets has led to renewed discussions on the lack of corporate governmental oversight. More and more people are recognizing that corporate governance is indispensable to effective market discipline. In an age where capital flows worldwide, just as quickly as information, a company that does not promote a culture of strong, independent oversight, risks its stability and future health. As a result, the link between a company's management, directors and its financial reporting system has never been more crucial.

5.8.1 Approach
To further improve the level of corporate governance, need was felt for a comprehensive approach, to accelerate the adoption of globally acceptable practices of corporate governance. This would ensure that the Indian investors are in no way less informed and protected as compared to their counterparts in the best developed capital markets of the world. The committee 31 is primarily concerned with the issues relating to audit committees, audit reports, independent directors, related parties, risk management, directors compensation, codes of conduct and financial disclosures. The Committee is of the view that the regulator (SEBI) should clearly define regulations and effectively enforce the recommendations. The regulations should be as few as possible and the role of the regulator should primarily be that of a catalyst in enforcement.

5.8.2 Agenda of Committee

1 - To suggest suitable amendments to the listing agreement in areas such as continuous disclosure of material information, both financial and non-financial, manner and frequency of such disclosures, responsibilities of independent and outside directors.

2 - To suggest safeguards to be instituted within the companies to deal with insider information and insider trading.

31

The Committee appointed by SEBI to report on Corporate Governance, Feb. 2003.

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5.8.3 Initiatives to improve Governance practices

It is strange but true that the early initiatives for better corporate governance in India came from the most enlightened listed companies and industry association. The first effort was made by The Confederation of Indian Industries (CII) by setting up National Task Force on Corporate Governance under chairmanship of Shri Rahul Bajaj in December 1995.The Corporate Governance movement began in 1997with a voluntary code framed by CII. In the next three years, almost 30 large companies, accounting for over 25% of Indian market capitalization, voluntarily adopted the code. It recommended a code of conduct for Indian companies in 1998. Though recommendations of this committee did not become regulations, they did generate debate on the necessity of good corporate governance practices in India. May, 1999, The Securities Exchange Board of India (SEBI) appointed a Committee on Corporate Governance under the chairmanship of Shri Kumar Mangalam Birla, to promote and raise the standards of Corporate Governance. The Committee's32 recommendations look at corporate governance from the point of view of the stakeholders and in particular that of the shareholders. The other perspective is the contribution of corporate governance, to the creation of wealth and to the countrys economy. The committee suggested mandatory and the non-mandatory recommendations in its report as well as schedule of their implementation. The mandatory recommendations of the committee were made regulation by inserting them as Clause 43 in Listing Agreement of the stock exchanges in India. December, 1999, The Reserve Bank of India (RBI) has set up a Standing Committee on international Financial Standards under the chairmanship of Shri (Dr.) R. H. Patil with the objectives of identifying and monitoring developments in global standards pertaining to various segments of the financial system. August 2002, the Department of Company Affairs (DCA) under the Ministry of Finance and Company Affairs appointed a committee under chairmanship of Shri Naresh Chandra to examine various corporate governance issues. The committee has been entrusted with analyzing and recommending changes if necessary, in various areas, like, statutory auditor-company relationship, independence of auditing functions, certification of accounts and financial statements by managers and directors, adequacy of regulation of chartered accountants, company secretaries, and cost accountants, and the role of independent directors, etc.

32

Committee Appointed by the SEBI (Securities and Exchange Board of India ) on Corporate Governance under the Chairmanship of Shri Kumar Mangalam Birla

58

The committee recommended detailed regulations on auditors independence, working of audit committees, board composition and governance. The recommendations have also been drawn from The Sarbanes-Oxley Act, 2002, of the U.S.A. These recommendations have been widely debated in public domain. If implemented, they may bring sweeping changes in governance systems in Indian corporate sector. The committee is also examining governance issues related to private companies in India. February, 2003, SEBI also appointed a committee under chairmanship of Shri Narayana Murthy to evaluate the adequacy of existing corporate governance practices and offer further recommendations to improve these practices.

5.8.4 Statutory Code of Governance

The Committee realized that a statutory rather than a voluntary code would be far more purposeful and meaningful under the Indian conditions. The Committee was convinced that it would raise the standards of governance, and strengthen the unitary board system.

5.8.5 First Code of Governance

The recommendations being made by the Committee are the first formal and comprehensive attempt, in the context of prevailing conditions of governance in Indian companies, as well as the state of capital markets. This code need to be reviewed from time to time, keeping pace with the changing expectations of the stakeholders and increasing sophistication achieved in capital market. The ultimate responsibility for putting the Code into practice however lies directly with the boards of directors. The committee felt that the implementation of some of the recommendations will require change in existing law. So, it would be desirable to divide the recommendations into mandatory and non-mandatory categories.

5.8.6 Published Code of Governance

In India, the CII (Confederation of Indian Industry) has published a Code of Corporate Governance. The Committee also took note of the various steps already taken by SEBI for strengthening corporate governance, some of which are: Strengthening the disclosure norms for Initial Public Offers following the recommendations of the

Committee under Shri Y H Malegam; 59

Providing information in directors report for utilization of funds and variation between projected

and actual use of funds according to the requirements of the Companies Act. inclusion of cash flow and funds flow statement in annual reports declaration of quarterly results; Mandatory appointment of compliance officer for monitoring the share transfer process and ensuring

compliance with various rules and regulations; timely disclosure of material and price sensitive information including details of all material events

having an effect on the performance of the company; Dispatch of one copy of complete balance sheet to every shareholder. issue of guidelines for preferential allotment at market related prices; and Issue of regulations providing for a fair and transparent framework for takeovers and substantial

acquisitions.

5.8.7 Implementation
The Committee recommends that the mandatory recommendations, such as composition of the Board, constitution of the various sub-committees of the Board of Directors, should be implemented by companies as follows:

Immediately, for all companies seeking listing for the first time.

By April 2000, for those companies, who have their Paid up share capital is Rs.100 million and

above; or net worth, has reached Rs. 250 million, any time in the history of the company.

By April 2001, for those companies, who have paid up share capital of Rs. 50 million and above.

Already listed companies were given time up to March 31, 2004 to comply with the Amendments made to clause 49 of listing agreement.

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6. OECD principles
These Principles offer non-binding standards and good practices will guide on implementation, which can be adapted to the specific circumstances of individual countries and regions. The Revised Principles shows OECDs contribution and commitment to strengthen the corporate governance around the world in the years ahead. This will make criminal activity more difficult, as rules and regulations are adopted in accordance with the Principles. This will also help to develop a culture for professional and ethical behavior for well functioning markets. Trust and integrity play an essential role in economic life and for the sake of business and future prosperity we have to make sure that they are properly rewarded. The Principles are intended to assist OECD and non-OECD governments in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance in their countries and to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance. They are intended to be concise, understandable and accessible to the international community. They are not intended to substitute for government, semi-government or private sector initiatives to develop more detailed best practice in corporate governance. The presence of an effective corporate governance system, within an individual company and across an economy as a whole, helps to provide a degree of confidence that is necessary for the proper functioning of a market economy. The corporate governance framework also depends on the legal, regulatory, and institutional environment. In addition, factors such as business ethics and corporate awareness of the environmental and societal interests of the communities in which a company operates can also have an impact on its reputation and its long-term success. In some countries, employees have important legal rights irrespective of their ownership rights. The Principles therefore have to be complementary to a broader approach to the operation of checks and balances. Some of the other issues relevant to a companys decision-making processes, such as environmental, anti-corruption or ethical concerns are taken into account. In the typical two tier system, found in some countries, board as used in the Principles refers to the supervisory board while key executives refers to the management board. In systems where the unitary board is overseen by an internal auditors body, the principles applicable to the board are also applicable. To remain competitive in a changing world, corporations must innovate and adapt their corporate governance practices so that they can meet new demands and grasp new opportunities. Similarly, governments have an important responsibility for shaping an effective regulatory framework that provides for sufficient flexibility to allow markets to function effectively. 61

6.1.1 Revised Governance Principles

SEBI, believe that the need to review the existing code on corporate governance arose from two perspectives, (a) to evaluate the adequacy of the existing practices, and (b) to further improve the existing practices. The Committee was constituted by SEBI, to evaluate the adequacy of existing corporate governance practices and further improve these practices. The Committee comprised

members from various public and professional lives. This includes captains of industry, academicians, public accountants and people from financial press and from industry forums. Since the India is at the early stages of developing governance framework, the focus of principles is at making the operations more transparent and visible to stakeholders. This will help to further improve existing practices and provide strong basis for adopting best governance framework.

I -Ensuring the Basis for Effective Governance Framework

The OECD supports the governance framework which promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities. The Committees recommendations in the final report were based on their relative importance, fairness, accountability, transparency, ease of implementation, verifiability and enforceability. The primary issues were related to audit committees, audit reports, independent directors, related parties, risk management, directorships and director compensation, codes of conduct and financial disclosures. The Committee agreed that India had in place a basic system of corporate governance and SEBI has taken a number of initiatives towards raising the existing standards. The Committee also recognized that the Confederation of Indian Industries had published a Desirable Code of Corporate Governance and encouraged that some of the forward looking companies are in the process of reviewing their board structures and reported in their 1998-99 annual reports the extent to which they have complied with the Code.

6.1.2 Key Constituents of Corporate Governance

Board of directors set strategic aim, the financial policy and oversee the implementation and the financial controls and report the progress of the company to the shareholders to whom they are accountable. The shareholders' role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the 62

management include ensuring that control systems are in place to achieve the objectives laid down by the board and to help the board discharge its responsibilities to the shareholders. The committee formed three subgroups to identify and define the rights, roles, responsibilities and accountability of each of these constituents. They were required to examine the existing situation, and the provisions of the existing laws, rules and regulations; define the desired situation; and make recommendations to the Committee. Another group formed to deal with issues related to insider information and insider trading. The existing accounting standards and auditing practices are corner stones of corporate governance. A separate Committee33 has been examining these issues in association with the Institute of Chartered Accountants of India.

6.1.3 Board Composition

The committee considered Literature on corporate governance while framing the recommendations on the structure and composition of the board. It has been practice in most of the Indian companies to fill the board with representatives of the promoters of the company. If independent directors were chosen, they were handpicked ceasing to be independent. Increasingly, the boards comprise of following groups of directors - promoter director, (promoters being defined by the erstwhile Malegam Committee), executive and non executive directors, a part of who are independent. Board composition determines the ability of the board to collectively provide the leadership and ensures that no one individual or a group is able to dominate the board. Among the three classes of directors, the executive directors (like director finance, director-personnel) are involved in the day to day management of the companies; the non-executive directors bring external and wider perspective and independence to the decision making.

6.1.4 Independent Directors

Independent Directors do not have any material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in the judgment of the board may affect their independence of judgment. Further, all pecuniary relationships or transactions of the non-executive directors should be disclosed in the annual report. The law does not make any distinction between the different categories of directors. Therefore, the committee is of the view that the non-executive directors bring an independent judgment to the boards deliberations especially on issues of strategy, performance, management of conflicts and standards of conduct.
33

A committee appointed by the SEBI under the Chairmanship of Shri Y H Malegam.

63

The Committee recommends that the board of a company should have an optimum combination of executive and non-executive directors with fifty percent of the board comprising the non-executive directors. The number of independent directors would depend on the nature of the chairman of the board. In case of a non-executive chairman, at least one-third of board should comprise of independent directors and in case of an executive chairman, at least half of board should be independent. This is a mandatory recommendation. The tenure of the directors will accord the Companies Act. According to the amendment in clause 49 of listing agreement, every company is required to have a certain percentage of independent directors on it boards depending upon whether or not the company has an executive chairperson.34

6.1.5 Nominee Directors

There is another set of directors in Indian companies who are the nominees of the financial institutions to safeguard their interest. The nominees of the institutions are often chosen from the present or retired employees of the institutions or from outside. The Committee recognizes role of financial institutions in the industrial development of the country. However, to avoid potential conflicts of interest, it is desirable that the financial institutions maintain an arms length relationship with the company by not seeking a seat on the board of a company, which would imply their involvement in the management of the company. Instead they would serve their cause and protect their interests better and provide direction to the individual shareholders if they make more effective and pro-active use of their significant voting power at the General meetings. They may also sell their holdings in the market which could have an adverse impact on the prices of the stocks. Besides, the investment institutions, by virtue of their position on the board of the company, become privy (share secret of something.) to unpublished price sensitive information. This could easily expose these institutions and their nominees to the charge of insider trading, when these institutions or their nominees deal in the securities of the company. By occupying a board seat, implicitly the nominee directors share equal responsibility as any other director on the board of the company. The Committee recommends that the financial institutions should have no direct role in managing the company, and not to have nominees on the board, by virtue of their financial exposure by way of investment in the securities of a company. There is possibility for lending institutions to have nominees on the Boards of the borrower companies, to protect their interests as creditors, in case of loan default.
34

Source: SEBI: Circular/SEBI/MRD/SE/31/2003/26/8 ,

Date August26, 2003.

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6.1.6 Chairman of the Board

Chairmans responsibility is to ensure that the board meetings are conducted to secure the effective participation of all directors, executive and non-executive. The Committee is of the view that the Chairmans role in principle be different from that of the chief executive. The Committee recommends that a non-executive Chairman should be entitled to maintain a Chairmans office at the companys expense. This is a mandatory recommendation.

6.1.7 Insider Trading

It is important that insiders do not use their position and access to inside information, to take unfair advantage over the uninformed stockholders and investors transacting in the stock of the company. To control this, the companies are expected to disclose price sensitive information in a timely and proper manner and also ensure that till such information is made public, insiders abstain from transacting in the securities of the company. The principle should be disclose or desist (stop someone doing something). This requires companies to devise an internal procedure for adequate and timely disclosures, reporting requirements, and code of conduct for its directors and employees with regard to their dealings in securities.

6.1.8 Audit Committee

The audit committee is a sub-group of the full board, and monitors the companys financial reporting process, where it relies on senior financial management, internal and outside auditors. . Certainly, it is not the role of the audit committee to prepare financial statements or engage in decisions relating to the preparation of those statements. If the boards are dysfunctional, the audit committees will do no better. The Committee believes that the standards of governance applicable to the full board should also be applicable to the audit committee. The Committee therefore recommends that a qualified and independent audit committee should be set up by the board of a company. This is a mandatory recommendation. The Composition of the audit committee is based on independence and expertise. The audit committee should have minimum three non executive directors, majority being independent, with at least one director having financial and accounting knowledge; 65

The chairman of the committee should be an independent director; he should be present at Annual General Meeting to answer shareholder queries;

The finance director, head of internal audit and a representative of external auditor should be present as invitees for the meetings.

The Company Secretary should act as the secretary of the committee. One meeting must be held before the closing of annual accounts and one necessarily every six months.

There must be either two members or one-third of the members, (whichever is higher), at committee meetings

The various committees of the board recommended would enable the board to discharge its responsibilities. The Committee recommends that board meetings should be held at least four times in a year, with a maximum time gap of four months between any two meetings. In order to ensure that the members of the board give due commitment to the meetings of the board and its committees, there should be a ceiling on the maximum number of committees across all companies in which a director could be a member or act as chairman. The Committee recommends that a director should not be a member in more than 10 committees or act as chairman of more than five committees across all companies in which he is a director. The committee further recommends that all audit committee members should be financially literate35 and at least one member should have accounting or related financial management expertise. As per the amendments, to clause 49, the Audit Committee is now required to review the following information on a mandatory basis: Financial statements and draft audit report; Management discussion and analysis of financial condition and results of operations; Reports relating to legal compliance and risk management; Management letters issued by statutory/internal auditors; Records of related party transactions; The compliance report of the Mumbai Stock Exchange showed that approximately 53% of the companies complied with this requirement. The committee further recommends that a statement of all transactions with related parties including their bases should be placed before the independent audit

35

The ability to read and understand basic financial statements

66

committee for formal approval / ratification. If any transaction is not on an arms length basis, management should provide an explanation to the audit committee justifying the same.

6.1.9 Whistle Blower Policy

Indian code asks the Personnel who observe an unethical or improper practice (not necessarily a violation of law) should be able to approach the audit committee without necessarily informing their supervisors. Companies shall take measures to ensure that this right of access is communicated to all employees through means of internal circulars, etc. The employment and other personnel policies of the company shall contain provisions protecting whistle blowers from unfair termination and other unfair prejudicial employment practices. Companies shall annually affirm that they have not denied any personnel to access the audit committee of the company (in respect of matters involving alleged misconduct) and that they have provided protection to whistle blowers from unfair termination and other unfair or prejudicial employment practices. The appointment, removal and terms of remuneration of the chief internal auditor must be subject to review by the Audit Committee. Such affirmation shall form a part of the Board report on Corporate Governance that is required to be prepared and submitted together with the annual report.

6.1.10 Harmonization
It was suggested to SEBI to harmonize the provisions of clause 49 of the Listing Agreement and those of the Companies Act, 1956. The Committee recognized that major differences between the requirements under clause 49 and the provisions of the Companies Act, 1956 should be identified. SEBI should then recommend to the Government that the provisions of the Companies Act, 1956 be changed to bring it in line with the requirements of the Listing Agreement.

6.1.11 Corporate Governance Ratings

It was suggested that corporate governance practices followed by companies should be rated using rating models. It was also suggested that companies should be rated based on parameters of wealth generation, and corporate governance. The Committee noted that corporate governance ratings are desirable, as this will provide a process of independent appraisal. Certain rating agencies have begun work in this area; however, the process is still in a development phase and may need to be evolved based on future experience. The Committee is of the view that for the time being, it should not be mandatory for 67

companies to be rated on corporate governance parameters. However, it should be left to the management of companies to decide whether they want to be rated or not, on corporate governance.

The emerging business of corporate governance rating may not add much value for stakeholders in India. The credit rating agencies have come up with corporate governance rating for a few companies such as INFOSYS. Such ratings would only add an extra element of routine to an issue that is largely subjective. In the process, if some companies with high quality governance enjoy modest price-earnings multiples, it is due to other factors such as trading interest and liquidity in the stock.

Corporate governance ratings as a concept may not uncover anything that is new. On the other hand, such ratings hold potential to mislead investors who may view the company in favorable light based on them. As a concept, corporate governance ratings run the risks that rating of debt instruments suffer from perhaps even to a greater extent. In the last two years, credit rating agencies have been effecting changes to their ratings with greater efficiency. If debt ratings can be a tough area, rating corporate governance in a complete manner can only be even more so.

The values element36: In all this routine regulatory emphasis on corporate governance, the big point
that is missed is the `values' brought to the table by the owners or managers. Companies, irrespective of what the owners/managers bring to the table, can comply with the routine required by SEBI. But, ultimately, the credibility of management and corporate governance is linked more to the values than necessarily the mere existence of audit committees and independent board members. The latter can at best serve as checks and balances.

This is a highly subjective area, which cannot be captured in the scope of ratings, excluding obvious cases such as INFOSYS at the top end. Given this critical aspect, it is just as well that the special SEBI committee on corporate governance headed by Mr N. R. Narayana Murthy, Chief Mentor of INFOSYS, has recommended that ratings should not be mandatory. SEBI and the rating agencies should view the regulatory prescription on these issues as potential checks and balances. It should not be confused with corporate governance.

36

S. Vaidya Nathan Apr 27, 2003. Business Line

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II - Rights of Shareholders 6.2.1 Shareholders

In real world companies cannot be managed by shareholder referendum. A companys management must be able to take business decisions rapidly. The relationship between management and owners through board of directors therefore brings in the accountability of the boards and the management to the shareholders of the company.

6.2.2 Rights
OECD stress that the basic rights should include the right to: 1) secure methods of registration; 2) transfer shares; 3) obtain relevant and material information on the corporation on a timely and regular basis; 4) participate and vote in general shareholder meetings; 5) elect and remove members of the board; and 6) share in the profits of the corporation. SEBI recognizes all rights as basic right and consider them while making policies and rules governing corporate and financial market. Disclosure requirements under listing agreements protect the share holder right to timely and relevant information on regular basis. OECD principles give Shareholders the right to participate in, and to be sufficiently informed on, the decisions concerning fundamental corporate changes such as: 1) amendments to the statutes, or articles of incorporation 2) the authorization for additional issue of shares; and 3) extraordinary transactions, including the transfer of substantial assets, that result in the sale of the company. The committee is of view as OECD principles, on ownership transfer, voting right and right to for relevant, timely information on regular basis. They recommend that as shareholders should have a right to participate in, and be sufficiently informed on decisions concerning fundamental corporate changes, they should not only be provided information as under the Companies Act, but also in respect of other decisions relating to material changes such as takeovers, sale of assets or divisions of the company, changes in capital structure which will lead to change in control or may result in certain shareholders obtaining control disproportionate to the equity ownership. SEBI also realize the need to protect the rights of minority share holders against the block holders, and institutional investors in decision making. Indian market is dominated mostly by block holders, family 69

groups, industrial groups, and institutional investors, so, it will take time to decrease the ownership concentration. Practically speaking the interests of minority owners are not well protected, but the governance practices are heading towards protecting them. In actual practice only a small fraction of the shareholders of a company do or can really participate. This virtually makes the concept of corporate democracy illusory. For shareholders who are unable to attend the meetings, there should be a requirement which will enable them to vote by postal ballot for key decisions such as investment proposals, appointment of directors, auditors, committee members, loans and advances above a certain percentage of net worth, changes in capital structure which will lead to change in control or may result in certain shareholders obtaining control disproportionate to equity shareholding, sale of assets or divisions and takeovers etc 37 With a view to strengthening shareholder democracy, it is felt that all the shareholders of a company should be given the right to vote on certain critical matters through a postal ballot system, which has also been envisaged in the Companies Bill, 1997. The Committee recommends a board committee under the chairmanship of a non-executive director for redressing shareholder grievances. The Committee believes that it will help to focus on shareholders grievances and sensitize the management to redress their grievances

6.2.3 Responsibilities
It is important for shareholders to use general body meetings for ensuring that the company is being stewarded for maximizing the interests of the shareholders. This is important especially in the Indian context, that for effective participation the shareholders must maintain polite and socially acceptable behavior during the General Body Meetings. The effectiveness of the board is determined by the quality of the directors. The shareholders must therefore show a greater degree of interest and involvement in the appointment of the directors and the auditors. The Committee recommends that in case of the appointment of a new director or re-appointment of a director, the shareholders must be provided with the following information: A brief resume of the director; Expertise in specific functional areas; and

37

A detailed list of the matters which should require postal ballot is given in Annexure 3 in the draft report of the Kumar Mangalam Committee on Corporate Governance Appointed by the SEBI.

70

Names of companies in which the person also holds the directorship and the membership of Committees of the board.

6.2.4 Institutional Investor

The Committee recommends that institutional investors maintain an arm's length relationship with management and do not seek participation at the board level which may make them privy to unpublished price sensitive information. Given the weight of their votes, the institutional shareholders can effectively use their powers to influence the standards of corporate governance.

What is important in the view of the Committee is that, the institutional shareholders put to good use of their voting power. The Committee recommends that the institutional shareholders should;

Take active interest in the composition of the Board of Directors Maintain regular and systematic contact at senior level for exchange of views on management, strategy, performance and the quality of management.

Ensure that voting intentions are translated into practice Evaluate the corporate governance performance of the company

The Committee recognizes that the listing agreement is not a very powerful instrument and the penalties for violation are not sufficiently stringent to act as a deterrent. The Committee therefore recommends to SEBI, that the listing agreement of the stock exchanges be strengthened and the exchanges themselves be vested with more powers, so that they can ensure proper compliance of code of Corporate Governance.

In this context the Committee recommends that the Securities Contract (Regulation) Act, 1956 should be amended, so that in addition to the above, the concept of listing agreement be replaced by listing conditions. Non-compliance of any section of the code of Governance and the reasons thereof should specifically be highlighted in the annual report. This will enable the shareholders and the securities market to assess the standards of corporate governance followed by a company.

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III. The Equitable Treatment of Shareholders

Indian corporate sector follows the convention of one share one voting right. So, in this respect they are different from some of the European countries, having A & B type of shares. But they do have preferred and ordinary class of shares, where preferred shareholders have preference over ordinary shareholder, eg in case of liquidation the preferred shareholders have preference over ordinary shareholders on corporate wealth. The Financial institution, whether as a lending institution or as investing institution, wishes to appoint its nominee on the Board; such appointment should be made through the normal process of election by the shareholders. This will help to protect the minority shareholders from abusive actions by, controlling shareholders or financial institutions. An institutional director38 shall have the same responsibilities and shall be subject to the same liabilities as any other director. Nominee of the Government on public sector companies shall be similarly elected and shall be subject to the same responsibilities and liabilities as other directors. OECD asks to eliminate Impediments to cross border voting. The Indian practices comply in a sense that foreign institutional investors are involved in decision making. As communication technology is growing in India, in near future online voting for strategic decisions is quite possible.

IV. The Role of Stakeholders in Corporate Governance

The OECD is of the view that rights of stakeholders established by law or through mutual agreements should be respected. Indian practices of corporate governance partially comply with OECD principle. Some of the Indian companies have put in place a system of employees welfare, and up to some extent they also involve them indecision making. But this is not common practice in medium small enterprises. BSES Ltd. attaches utmost importance to employee welfare measures, particularly being a utility service provider, it is critical that the Company focuses on training and motivation of manpower so as to develop teams of skilled personnel for achieving customer satisfaction through quality service. Bajaj Auto Ltd. has launched a vendor development programmer called Scorpio. It is aimed at

improving quality and cost of supplies, enhancing product development capability. Under this programmer, companys engineering expertise has been deployed in many vendor units to improve productivity, layout, technology etc. Often, the machinery has also been leased to them. The Company
38

A director representing the board, as institutional investor.

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invests in upgrading their employees technical and commercial skills. It has also pioneered a computer based communication system with them. OECD describes that the Stakeholders, including individual employees and their representative bodies, should be able to freely communicate their concerns about illegal or unethical practices to the board and their rights should not be compromised for doing this. SEBI recommends for the protection of whistle blower (whether employee, auditor or independent director), against unethical or unlawful practices. All these practices are aligned with OECD principles as Role of Stake holders to develop best governance practices.

V- Disclosure and Transparency

OECD says that Disclosure should include material information on related party transactions. Indian policy makers agree with OECD principles on this issue. They recommend that a statement of all transactions with related parties including their bases should be placed before the independent audit committee for formal approval / ratification. If any transaction is not on an arms length basis, management should provide an explanation to the audit committee to justify the same. The committee says that Procedures should be in place to inform Board members about the risk assessment and minimization procedures. These procedures should be periodically reviewed to ensure that executive management controls risk through means of a properly defined framework. Management should place a report before the entire Board of Directors every quarter documenting the business risks faced by the company, measures to address and minimize such risks, and any limitations to the risk taking capacity of the corporation. This document should be formally approved by the Board. This will help the investors decision to invest in the companies, and ask for high returns for risky investments. Indirectly it gives protection to real owners and enables them to stop unnecessary risk taking by management. Clause 51 (EDIFAR), Companies have been required to file certain statements/ information viz. financial statements, corporate governance report, shareholding pattern, action taken against the company by any regulatory agency. EDIFAR was launched on July 05, 2002 and initially top 200 companies listed at BSE and NSE where required to comply with filings. Thereafter, every quarter 500 companies are added for filing and now it is applicable to 2200 companies. The current filing requirements are: The quarterly financial statements, shareholding pattern reports and the segment reports uploaded in the financial statements 73

The Annual reports inclusive of the directors report, auditors report, Corporate Governance Report, Cash Flow Statement, Balance Sheet etc.

The alternative format for providing the annual audited statements instead of the un-audited results for the last quarter.

Companies are required to publish along with the quarterly un-audited/audited financial results the number of investor complaints received, disposed off and lying unresolved at the end of the each quarter after June 30, 2003. In order to ensure that listed companies do not in anyway violate the provisions of securities laws or the stock exchange requirements, the Listing agreement has been amended to provide for Filing of any scheme/petition proposed to be filed before any Court or Tribunal under sections 391, 394 and 101 of the Companies Act, 1956, with the stock exchange, for approval, at least a month before it is presented to the Court or Tribunal. The company shall ensure that any scheme of arrangement/amalgamation/merger/reconstruction/ reduction of capital, etc., to be presented to any Court or Tribunal does not in any way violate, or override the provisions of securities laws or the stock exchange requirements. Current provisions of the listing agreement also require companies to provide details regarding audit qualifications. The recent amendment to the Listing Agreement also provides that in case of audit qualifications, stock exchanges shall ask the companies to explain Why there is audit qualification in their accounts, Why the company failed to publish accounts without audit qualifications and When the company will remove the qualifications and publish account without qualifications. It has been mandated that Exchanges shall also inform SEBI within 7 days from the date of submission of relevant audited results of cases where companies have failed to remove audit qualifications. An Advisory Committee has to be constituted to examine the cases reported by the stock exchanges where companies have failed to remove audit qualifications. This Committee shall advise SEBI to refer the matter to Department of Company Affairs (DCA) to initiate necessary action under Companies Act and also to ICAI39 in cases where actions are required against the auditors of the company. To ensure the reliability of disclosure the accountability of auditor under Indian code comply with OECD principles, where it asks for external auditors to be held accountable to the shareholders and owe a duty to the company to exercise due professional care in the conduct of the audit.

39

Institute of Chartered Accountants of India

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Companies should publish their compensation philosophy and statement of entitled compensation in respect of non-executive directors in their annual report. Non-executive directors should be required to disclose their stock holding (both own or held by / for other persons on a beneficial basis) in the listed company in which they are proposed to be appointed as directors, prior to their appointment. This code also comply with disclosure requirements, and makes companys operations more transparent to owners. Changes in disclosure and reporting practices through listing agreement over a period of time have brought the current disclosures almost at par with international practices and some disclosure and reporting practices are better than the global benchmarks. Without quality information, investor confidence erodes, liquidity dries up, and fair and efficient markets simply cease to exist. Thus it is essential that provisions prescribed under the listing agreement should aim at ensuring quality of information and one way to achieve this objective could be to continue with the practice of interacting with the market participants through various committees. The current form of listing agreement generally seeks to achieve the following objectives: Ensure timely disclosure of all material information that may have bearing on the security values or influence investment decisions, and in which stakeholders have a warrantable interest. Ensure frequent, regular and timely publication of financial reports prepared in accordance with generally accepted accounting principles. Provide the Exchange with timely information to enable it to efficiently perform its function of maintaining an orderly market for the companys securities, to enable it to maintain necessary records and to allow it the opportunity to make comment as to certain matters before they become established facts. Encourage and ensure adoption of best corporate governance and reporting practices

6.2.5 Real and Timely Disclosure

It was suggested to the SEBI to issue rules relating to real-time disclosures of certain events or transactions that may be of importance to investors, within 3-5 business days, e-g (a) change in the control (b) companys acquisition / disposal of a significant amount of assets, (c) bankruptcy (d) change in the independent auditors, and (e) the resignation of a director. But there are certain practical problems in ensuring timely disclosures; e-g a business transaction that is under negotiations may have an impact on the market price. However, its disclosure may prejudice the underlying business negotiations. 75

6.2.6 Disclosure Related to Management

The Committee recommends that, Management Discussion and Analysis report should form the part of the annual report to the shareholders. This Management Discussion & Analysis should include the following within the limits set by the companys competitive position: Companies are required to make a clear disclosure of contingent liabilities, all elements of remuneration, details of fixed and performance based components, service contracts, stock option details, etc., in the annual report. Further, all compensation paid to non-executive directors, in addition to being fixed by the Board of Directors, is required to be approved by the shareholders in a general meeting.

VI. The Responsibilities of the Board

The Birla Committee Report defined the roles and responsibilities of management and board. It is obligatory for the Board of Directors to define a code of conduct for itself and the senior management. This code of conduct shall be posted on the website of the company. All Board members and senior management personnel shall comply with the code on an annual basis in the annual report signed off by the CEO. This will make the board activities more transparent. This principle is aligned with OECD rules of governance where they ask the board for effective monitoring of management, and the board should apply high ethical standards, while taking into account the interests of stakeholders. Under the clause 49 of listing agreement companies are required to have an optimum combination of executive and non executive directors with not less than 50% of the board comprising of non executive directors. The non-executive directors are those who are independent and help to bring an independent judgment on issues of strategy, performance, management of conflicts and standards of conduct. Independent directors are directors who apart from receiving directors remuneration do not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in the judgment of the board may affect their independence of judgment. Further, all pecuniary relationships or transactions of the non-executive directors should be disclosed in the annual report. When a nominee of the institutions is appointed as a director of the company, he should have the same responsibility, be subject to the same discipline and be accountable to the shareholders in the same manner as any other director of the company. In particular, if he reports to any department of the institutions on the affairs of the company, the institution should ensure that there exist Chinese walls between such department and other departments which may be dealing in the shares of the company in 76

the stock market. Practically speaking, the requirement of Chinese wall between the two departments in same institution looks difficult to enforce, except having monitoring system in place. OECD describes the board responsibility to Select, compensate, monitor and, when necessary, replacing key executives. Indian code partially comply where it requires that all compensation paid to nonexecutive directors may be fixed by the Board of Directors and should be approved by shareholders in general meeting. Limits should be set for the maximum number of stock options that can be granted to non-executive directors. This will help to avoid the concentration of powers in to the board, and to create balance of powers among owners. To create harmony in the governance practices between parent and subsidiary, the committee recommends that the provisions relating to the composition of the Board of Directors of the holding company should be made applicable to the composition of the Board of Directors of subsidiary companies. At least one independent director on the Board of Directors of the parent company shall be a director on the Board of Directors of the subsidiary company. The Audit Committee of the parent company shall also review the financial statements, in particular the investments made by the subsidiary company. The Board report of the parent company should state that they have reviewed the affairs of the subsidiary company also. The committee strongly recommended that independent directors should periodically review legal compliance reports prepared by the company as well as steps taken by the company to cure any taint. In the event of any proceedings against an independent director in connection with the affairs of the company, defense should not be permitted on the ground that the independent director was unaware of this responsibility.

6.2.7 Implementation
The Committee realized that the recommendations can be implemented by means of an amendment to the Listing Agreement, with changes made to the existing clause 49. But the primary issue is that whether the recommendations should be made applicable to all companies immediately or in a phased manner since the costs of compliance may be large for certain companies. Another issue is whether to extend the applicability of these recommendations to companies that are registered with BIFR40. In the case of such companies, there is likely to be almost little or no trading in their shares on the stock exchanges. The Committee believes that the recommendations should be implemented for all

companies to which clause 49 apply. This would also continue to apply to companies that have been registered with BIFR, subject to any directions that BIFR may provide in this regard.

40

Board for Industrial & Financial Reconstruction

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A Comparative Table

Sr. No41

OECD Corp. Governance Framework

Should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.

Indian Governance Code and Practices42

The Committee agreed that India had in place a basic system of corporate governance. The primary issues were related to audit committees, independent directors, related parties, and director compensation, codes of conduct and financial disclosures.

Ib

The legal and regulatory requirements that affect corporate governance practices in a jurisdiction should be consistent with the rule of law, transparent and enforceable.

The Committee recognized the major differences between the requirements under clause 49 of listing agreement and the provisions of the Companies Act, 1956.The committee suggested SEBI to recommend the Government to bring in line the Companies Act, 1956 with the requirements of the Listing Agreement.

II

Right to: 1) secure methods of registration & transfer of shares; 3) obtain relevant, & material information on regular basis; 4) participate and vote in shareholder meetings; 5) elect and remove members of the board; and 6) share in the profits.

Recognizes all rights as basic rights and consider them while framing policies and rules governing corporate and financial market.43

IIb

Shareholders should have the right to participate in, and to be sufficiently informed on, decisions concerning fundamental corporate changes such as: amendments to the articles of incorporation 2) additional shares issue; and 3) transfer of all or substantial assets

They should not only be provided information under Companies Act, but also in respect of other decisions relating to material changes such as takeovers, sale of substantial assets or divisions of the company, or changes in capital structure

IId

Capital structures and arrangements that enable certain shareholders to obtain a degree of control disproportionate to their equity ownership should be disclosed.

Clause 40 of listing agreement provided for making a public offer to the shareholders of a company by person who sought to acquire 25% or more of voting rights of a company. In liberalization process the limit was reduced to 10%.

41 42

Serial No. refers to the sections and subsections of OECD principles 2004.

The corresponding Indian codes to OECD principles of Corporate Governance, are taken from the Report on CG by Shri Rahul Bajaj (December 1995), Kumar Mangalam Birla Committees report on CG (May 1999), Report on CG by a committee under chairmanship of Shri Narayana Murthy (February 2003), Companies Act 1956, and Clause 40 & 49 of listing agreement. Clause 49 is given in enclosure.

43

Details are given in clause 49 0f listing agreement (see enclosure).

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IIIa4

Impediments to cross border voting should be eliminated.

In Indian Corporate sector foreign institutional investors are involved in decision making. The growing communication technology in India will support online voting for strategic decisions.

IIIC

Members of the board and key executives should be required to disclose to the board whether they, directly, indirectly or on behalf of third parties, have a material interest in any transaction or matter directly affecting the corporation.

The committee recommended companies to devise an internal procedure for adequate and timely disclosures, and code of conduct for its directors and employees with regard to their dealings in securities.

IVC

Performance-enhancing mechanisms for participation should be permitted to develop.

employee

Some of the Indian companies have put in place a system of employees welfare, and up to some extent they also involve them indecision making. (But not common in SMEs)

IVE

Stakeholders, including individual employees and their representative bodies, should be able to freely communicate their concerns about illegal or unethical practices to the board and their rights should not be compromised for doing this.

Recommends for the protection of whistle blower (whether employee, auditor or independent director), against unethical or unlawful practices.

VA4

Disclosure should include, but not be limited to, material information on remuneration policy for members of the board and key executives, and information about board members, including their qualifications, the selection process, other company directorships and whether they are regarded as independent by the board.

Companies should publish their compensation philosophy and statement of entitled compensation (including the details of fixed and performance based components, service contracts, and stock option details) in respect of non-executive directors in their annual report. Non-executive directors should be required to disclose their stock holding (both own or held by / for other persons on a beneficial basis) in the listed company in which they are proposed to be appointed as directors, prior to their appointment.

VA5

Disclosure should include, but not be limited to, material information on Related party transactions.

A statement of all transactions with related parties including their bases should be placed before the independent audit committee for formal approval / ratification. If any transaction is not on an arms length basis, management should provide an explanation to the audit committee to justify the same. Procedures should be in place to inform Board members about the risk assessment and minimization procedures, and should be periodically reviewed. Management should place a report to the entire Board every quarter documenting the business risks faced by the company, measures to address and minimize such risks, and any limitations to the risk taking capacity of the corporation. This document should be formally approved by the Board. It is obligatory for the Board of Directors to define a code of conduct for itself and the senior management. This code of conduct shall be posted on the website of the company. All Board members and senior management personnel shall comply with the code on an annual basis in the annual report signed off by the CEO.

VA6

Disclosure should include, but not be limited to, material information foreseeable risk factors.

VIC VID2

The board should apply high ethical standards. It should take into account the interests of stakeholders. Monitoring the effectiveness of the companys governance practices and making changes as needed.

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VID3

The board should Select, compensate, monitor and, when necessary, replace key executives and oversee succession planning.

Describes that all compensation paid to non-executive directors may be fixed by the Board of Directors and should be approved by shareholders in general meeting. Limits should be set for the maximum number of stock options that can be granted to nonexecutive directors.

VIE1

Boards should consider assigning a sufficient number of nonexecutive board members capable of exercising independent judgment to tasks where there is a potential for conflict of interest. Examples of such key responsibilities are ensuring the integrity of financial and non-financial reporting, the review of related party transactions, nomination of board members and key executives, and board remuneration.

Recognize the Chairmans role in principle be different from that of the chief executive. The non-executive Chairmans responsibility is to ensure that the board meetings are conducted to secure the effective participation of all directors, executive and non-executive

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6.2.8 Conclusion
There are several corporate governance structures available in the developed world, but there is no one structure, which can be singled out as being better than the others. There is no one size fits all structure for corporate governance. The Committees recommendations are not, therefore, based on any one model, but, are designed for the Indian environment. Corporate governance extends beyond corporate law. Its fundamental objective is not mere fulfillment of the requirements of law, but, in ensuring commitment of the Board in managing the company in a transparent manner for maximizing long-term shareholder value. Corporate governance has as many votaries as claimants. Among the latter, the Committee has primarily focused its recommendations on investors and shareholders, as they are the prime constituencies of SEBI. Effectiveness of a system of corporate governance cannot be legislated by law nor can any system of corporate governance be static. In a dynamic environment, systems of corporate governance need to continually evolve. The Committee believes that its recommendations raise the standards of corporate governance in Indian firms and make them attractive for domestic and global capital. These recommendations will also form the base for further evolution of the structure of corporate governance in consonance with the rapidly changing economic and industrial environment of the country. Although corporate governance has been slow in making its mark in India, the next few years will see a flurry of activity. This will be driven by the force of competition. With the dismantling of licenses and controls, reduction of import tariffs and quotas, virtual elimination of public sector reservations, and a much more liberalized regime for foreign direct and portfolio investments, Indian companies have faced more competition in the second half of the 1990s than they did since independence. Competition has forced companies to drastically restructure their ways of doing business. Underutilized assets are being sold and capital is being utilized like never before. Moreover, while there have been losers in

liberalization, competition has led to greater over all profits. Thus, the aggregate financial impact of competition has been positive. Many companies and business groups that were on the top of the pecking order in 1991 have been relegated to the bottom. Simultaneously, new aggressive companies have clawed their way to the top. By and large, these are firms managed by relatively young, modern, outward-oriented professionals who place a great deal of value on corporate governance and transparency for facilitating access to

81

international and domestic capital. Therefore, they are more than willing to have professional boards and voluntarily follow disclosure standards that measure up to the best in the world. There has been a phenomenal growth in market capitalization. The market capitalization for a common sample of 1,322 companies that were listed on 1st April 1991 was Rs.678 billion (or $38 billion at the prevailing exchange rate). On 28 February 2000, their market cap stood at Rs.5.52 trillion (or $127 billion). For all companies taken together, the market cap on 28 February 2000 was Rs.Rs.10.3 trillion (or $236 billion). One cannot exaggerate the impact of well focused, well researched foreign portfolio investors. The cumulative net foreign portfolio investment increased from $827 million (December 1993), to $10.2 billion (December 1999). These investors have steadily raised their demands for better corporate governance, more transparency and greater disclosure. And given their clout in the secondary market they account for over 15% of the average daily volume of trade. Over the last two years, they have systematically increased their exposure in well governed firms at the expense of poorly run ones. The pressure on corporate governance will increase with the entry of foreign pension funds. Indian equity offers very attractive dollar-denominated rates of return on capital, which will attract funds like CalPERS, Hermes or TIAA-CREF to invest in Indian stocks. These funds hold their investments much longer than mutual funds; and their fund managers will be looking even more closely at corporate governance before making their investments. Indeed, it is fair to predict that in the next five years, the biggest pension funds will invest in India, and some of them will, like CalPERS, put Indian companies on their corporate governance watch. India has a strong financial press, which will get stronger with the years. In the last five years, the press and financial analysts have induced a level of disclosure that was inconceivable a decade ago. This will force companies to become more transparent concerning the matters to internal governance. Despite the weak Indian bankruptcy provisions, neither banks nor DFIs will continue to support management irrespective of performance. More aggressive and market oriented DFIs have started converting some of their outstanding debt to equity, and setting up mergers and acquisition subsidiaries to sell their shares in underperforming companies to more dynamic entrepreneurs and managerial groups. Indian corporations have realized that good corporate governance and internationally accepted standards of accounting and disclosure can help them to access the US capital markets. Until 1998, this was only in theory. It changed with Infosys making its highly successful Nasdaq issue in March 1998. This was followed five more US depository issues ICICI (which is listed on NYSE), Satyam Infoways (Nasdaq), ICICI Bank (NYSE), Rediff (Nasdaq), and WIPRO (NYSE). At this point, there at least ten companies gearing up to issue US depository receipts, and all of them will get listed either of NYSE and Nasdaq. 82

This trend has had two major beneficial effects. First, it has shown that good governance pays off in spades, and allows companies to access the worlds largest capital market. Second, it has demonstrated that good corporate governance and disclosures are not difficult to implement and that Indian companies can do all that is needed to satisfy US investors and the SEC. The message is now clear: it makes good business sense to be a transparent, well governed company incorporating internationally acceptable accounting standards. Finally, in a couple of years India will move to full capital account convertibility. When that happens, an Indian investor will seriously consider whether to put his funds in an Indian company or to place it with a foreign mutual or pension fund. That kind of freedom will be the ultimate weapon in favor of good corporate governance. It may not be wrong to predict that, by the end of 2005, India might have the largest concentration of well governed companies in South and South-east Asia.

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R E F E R E N C E S
Articles & Papers:
Arthur Andersen Enterprise Group and National Small Business United, Survey result of small and middle market business, (July 1992) Agrawal & C. Knober, Firm performance and mechanisms to control agency problems between managers and shareholders. Journal of Financial and Quantitative Analysis, 31:pp.377-397, 1996. Gautam Ahuja and Sumit K. Majumdar, An assessment of the performance of Indian state-owned enterprises. Journal of Productivity Analysis, 9:pp.113 {132, 1998}. Bagchi, A.K. (1999) Indian Economic Organizations in comparative perspective Shleifer A, Vishny R. 1986. Large shareholders and corporate control. Journal of Political Economy 94: 461-488 Richard B. & W Gibb Dyer, Managing continuity in the family-owned business & Organizational Dynamics, 1983, (7-8) Sytse Douma, & Rejie George, Tilburg University and Cochin University, Foreign and Domestic Ownership, Business Groups and Firm Performance: evidence from large Emerging Market (India), October 2003. Harold Demsetz and Kenneth Lenn. The structure of corporate ownership: Causes and consequences. Journal of Political Economy, 93,no.6:pp.1155-1177, 1985. E. Fama and M. Jensen. Separation of ownership and control, Journal of Law and Economics, 26:pp.301-325, 1983. D. F. Kuratko & H. P. welsh, Strategic entrepreneurial Growth, family based succession, 2001 Leora F. Klapper & Inessa Love, Corporate Governance, Investor Protection, and Performance in Emerging Markets, April 2002. Leora F. Klapper , Corporate Governance, Investor Protection, and Performance in Emerging Markets, April 2002 Nandini Gupta. Partial privatization and firm performance, Willian Davidson Working Paper:426, 2001. Omkar Goswami, The Tide Rises, Gradually, Corporate Governance in India Chief Confederation of Indian Industry New Delhi, India. Economist

Allen JW, Phillips, GM. 2000. Corporate equity ownership, strategic alliances and product market relationships. Journal of Finance 55: 2791-2815 84

Barney JB. 1991. Firm resources and sustained competitive advantage. Journal of Management 17: 99120 Sarkar J, Sarkar S. 2000. Large shareholder activism in corporate governance in developing countries: Evidence from India. Working Paper, Indira Gandhi Institute forDevelopment Research, Mumbai, India Jayesh Kumar 2003, Ownership Structure and Corporate Firm Performance, Indira Gandhi Institute of Development Research, Mumbai, India. Pradeep K. Chibber and Sumit K. Majumdar. State as investor and state as owner: Consequences for firm performance in india. Economic Development and Cultural Change, 46,no.3:pp.561-580, 1998. Pradeep K. Chibber and Sumit K. Majumdar. Foreign ownership and profitability: Property rights, control, and the performance of firms in indian industry. The Journal of Law and Economics, XLII:pp.209-238, 1999. Tarun Khanna and Krishna Palepu. Emerging markets business groups, foreign investors and corporate governance. NBER 6955, 1999. Tarun Khanna and Krishna Palepu. Is group affiliation profitable in emerging markets? an analysis of diversified indian business groups. The Journal of Finance, LV, no.2: pp.867-891, 2000. Sumit K. Majumdar. Assesing comperative e_ciency of the state owned mixed and private sectors in indian industry. Public Choice, 96:pp.1-24, 1998. Bertrand M, Mehta P, Mullainathan S. 2002. Ferreting out tunneling: An application to Indian business groups. Quarterly Journal of Economics 117: 121-148 Peteraf MA. 1993. The cornerstones of competitive advantage: a resource-based view. Strategic Management Journal 14: 179-191 Murali Patibandla. Equity pattern, corporate governance and performance: A study of indian corporate sector. Copenhagen Business School, working paper, 2002. Chibber PK, Majumdar SK. 1999. Foreign ownership and profitability: property rights, control and the performance of firms in Indian industry. Journal of Law and Economics 42: 209-238 Mohanty P. 2003. Institutional investors and corporate governance in India. SSRN Working paper series. Aggarwal R, Klapper L, Wysocki PD. 2003. Portfolio preferences of institutional investors, Working Paper, Georgetown University Dharwadkar R, George G, Brandes, P. 2000. Privatization in emerging economies: an agency theory perspective. Academy of Management Review 25: 650-669 A. Shleifer and R. Vishny. Value maximisation and the acqvision process. Journal of conomic Perspective, 2:pp.7{20, 1988. 85

Jayati Sarkar and Subrata Sarkar. India Development Report, Ed. by Kirit Parikh chapter The Governance of Indian Corporates, pages pp.201{218. Oxford University Press, 1999. Khanna T, Palepu K. 2000b. Is group affiliation profitable in emerging markets? An analysis of diversified Indian business groups. Journal of Finance 55: 867-891 Khanna T, Rivkin JW. 2001. Estimating the performance effects of business groups in emerging markets. Strategic Management Journal 22: 45-74 The Draft Report of the Committee Appointed by the SEBI on Corporate Governance under the Chairmanship of Kumar Mangalam Birla, 1998.

Report of the SEBI Committee on Corporate Governance, By N. R Narayana Murthy February 8, 2003. SEBI, Bulletin Vol. 1, Number. 12, December 2003. OECD: Corporate Governance in Asia - A Comparative Perspective, OECD, 2001.

Website Links:
www.investopedia.com www.Oecd.org

Periodicals & News Papers:

Reliance Group

Ownership issue Daily Business, November 18, 2004

Reserve Bank of India Annual Report 2000-01, Manjeet Kripalani Jul 31 '2000, Business Week N R MOORTHY, TUESDAY, OCTOBER 14, 2003, Business Week The Economic Times Friday August 13, 2004

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E N C L O S U R E S Contents of Companies Act, 1956

Securities Contracts (Regulation) Act, 1956. It covers all types of tradable government paper, shares, stocks, bonds, debentures and any other form of marketable securities issued by companies, including the rights and interest in securities thus effectively allowing for options. The SCRA defines the parameters of conduct of stock exchanges as well as its powers. Securities and Exchange Board of India (SEBI) Act, 1992. This established the independent capital market regulatory authority, SEBI, with the objective to protect the interests of investors in securities and to promote and regulate the securities markets. Sick Industrial Companies (Special Provisions) Act, 1985. This Act, popularly known as SICA, lays down the framework for bankruptcy restructuring of financially distressed companies.

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Clause 49 of Listing Agreement on Corporate Governance

I. Board of Directors

A) The company agrees that the board of directors of the company shall have an optimum combination of executive and non-executive directors with not less than fifty percent of the board of directors comprising of non-executive directors. The number of independent directors would depend whether the Chairman is executive or non-executive. In case of a non-executive chairman, at least one-third of board should comprise of independent directors and in case of an executive chairman, at least half of board should comprise of independent directors. Explanation: For the purpose of this clause the expression independent directors means directors who apart from receiving directors remuneration, do not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in judgment of the board may affect independence of judgment of the director. B) The company agrees that all pecuniary relationship or transactions of the non-executive directors vis--vis. the company should be disclosed in the Annual Report.

II Audit Committee
A) The company agrees that a qualified and independent audit committee shall be set up and that: a) The audit committee shall have minimum three members, all being non-executive directors, with the majority of them being independent, and with at least one director having financial and accounting knowledge; b) The chairman of the committee shall be an independent director; c) The chairman shall be present at Annual General Meeting to answer shareholder queries; d) The audit committee should invite such of the executives, as it considers appropriate (and particularly the head of the finance function) to be present at the meetings of the committee, but on occasions it may also meet without the presence of any executives of the company. The finance director, head of internal audit and when required, a representative of the external auditor shall be present as invitees for the meetings of the audit committee; e) The Company Secretary shall act as the secretary to the committee. B) The audit committee shall meet at least thrice a year. One meeting shall be held before finalization of annual accounts and one every six months. The quorum shall be either two members or one third of the members of the audit committee, whichever is higher and minimum of two independent directors. C) The audit committee shall have powers which should include the following: a) To investigate any activity within its terms of reference. b) To seek information from any employee. c) To obtain outside legal or other professional advice. d) To secure attendance of outsiders with relevant expertise, if it considers necessary. D) The company agrees that the role of the audit committee shall include the following. a) Oversight of the companys financial reporting process and the disclosure of its financial information to ensure that the financial statement is correct, sufficient and credible. b) Recommending the appointment and removal of external auditor, fixation of audit fee and also approval for payment for any other services. 88

c) Reviewing with management the annual financial statements before submission to the board, focusing primarily on; Any changes in accounting policies and practices. Major accounting entries based on exercise of judgment by management. Qualifications in draft audit report. Significant adjustments arising out of audit. The going concern assumption. Compliance with accounting standards. Compliance with stock exchange and legal requirements concerning financial statements. Any related party transactions i.e. transactions of the company of material nature, with promoters or the management, their subsidiaries or relatives etc. that may have potential conflict with the interests of company at large. d) Reviewing with the management, external and internal auditors, and the adequacy of internal control systems. e) Reviewing the adequacy of internal audit function, including the structure of the internal audit department, staffing and seniority of the official heading the department, reporting structure coverage and frequency of internal audit. f) Discussion with internal auditors any significant findings and follow up there on. g) Reviewing the findings of any internal investigations by the internal auditors into matters where there is suspected fraud or irregularity or a failure of internal control systems of a material nature and reporting the matter to the board. h) Discussion with external auditors before the audit commences nature and scope of audit as well as has post-audit discussion to ascertain any area of concern. i) Reviewing the companys financial and risk management policies. j) To look into the reasons for substantial defaults in the payment to the depositors, debenture holders, shareholders (in case of non payment of declared dividends) and creditors. E) If the company has set up an audit committee pursuant to provision of the Companies Act, the company agrees that the said audit committee shall have such additional functions / features as is contained in the Listing Agreement. III. Remuneration of Directors A) The company agrees that the remuneration of non-executive directors shall be decided by the board of directors. B) The company further agrees that the following disclosures on the remuneration of directors shall be made in the section on the corporate governance of the annual report. All elements of remuneration package of all the directors i.e. salary, benefits, bonuses, stock options, pension etc. Details of fixed component and performance linked incentives, along with the performance criteria. Service contracts, notice period, severance fees. Stock option details, if any and whether issued at a discount as well as the period over which accrued and over which exercisable. IV. Board Procedure A) The company agrees that the board meeting shall be held at least four times a year, with a maximum time gap of four months between any two meetings. The minimum information to be made available to the board is given in AnnexureI. 89

B) The company further agrees that a director shall not be a member in more than 10 committees or act as Chairman of more than five committees across all companies in which he is a director. Furthermore it should be a mandatory annual requirement for every director to inform the company about the committee positions he occupies in other companies and notify changes as and when they take place.

V. Management
A) The company agrees that as part of the directors report or as an addition there to, a Management Discussion and Analysis report should form part of the annual report to the shareholders. This Management Discussion & Analysis should include discussion on the following matters within the limits set by the companys competitive position: a) Industry structure and developments. b) Opportunities and Threats. c) Segmentwise or product-wise performance. d) Outlook e) Risks and concerns. f) Internal control systems and their adequacy. g) Discussion on financial performance with respect to operational performance. h) Material developments in Human Resources / Industrial Relations front, including number of people employed. B) Disclosures must be made by the management to the board relating to all material financial and commercial transactions, where they have personal interest, that may have a potential conflict with the interest of the company at large (for e.g. dealing in company shares, commercial dealings with bodies, which have shareholding of management and their relatives etc.)

VI. Shareholders
A) The company agrees that in case of the appointment of a new director or re-appointment of a director the shareholders must be provided with the following information: a) A brief resume of the director; b) Nature of his expertise in specific functional areas; and c) Names of companies in which the person also holds the directorship and the membership of Committees of the board. B) The company further agrees that information like quarterly results, presentation made by companies to analysts shall be put on companys web-site, or shall be sent in such a form so as to enable the stock exchange on which the company is listed to put it on its own web-site. C) The company further agrees that a board committee under the chairmanship of a non-executive director shall be formed to specifically look into the redressing of shareholder and investors complaints like transfer of shares, non-receipt of balance sheet, non-receipt of declared dividends etc. This Committee shall be designated as Shareholders/Investors Grievance Committee. D) The company further agrees that to expedite the process of share transfers the board of the company shall delegate the power of share transfer to an officer or a committee or to the registrar and share transfer agents. The delegated authority shall attend to share transfer formalities at least once in a fortnight. VII. Report on Corporate Governance The company agrees that there shall be a separate section on Corporate Governance in the annual reports of company, with a detailed compliance report on Corporate Governance. Non compliance of any mandatory requirement i.e. which is part of the listing agreement with reasons there of and the extent to which the non-mandatory requirements have been adopted should be specifically highlighted. The 90

suggested list of items to be included in this report is given in Annexure-2 and list of non-mandatory requirements is given in Annexure 3. VIII. Compliance The company agrees that it shall obtain a certificate from the auditors of the company regarding compliance of conditions of corporate governance as stipulated in this clause and annexes the certificate with the directors report, which is sent annually to all the shareholders of the company. The same certificate shall also be sent to the Stock Exchanges along with the annual returns filed by the company. Schedule of Implementation: The above amendments to the listing agreement have to be implemented as per schedule of implementation given below: By all entities seeking listing for the first time, at the time of listing. Within financial year 2000-2001,but not later than March 31, 2001 by all entities, which are included either in Group A of the BSE or in S&P CNX Nifty index as on January 1, 2000. However to comply with the recommendations, these companies may have to begin the process of implementation as early as possible. Within financial year 2001-2002,but not later than March 31, 2002 by all the entities which are presently listed, with paid up share capital of Rs. 10 crore and above, or net worth of Rs 25 crore or more any time in the history of the company. Within financial year 2002-2003,but not later than March 31, 2003 by all the entities which are presently listed, with paid up share capital of Rs.3 crore and above As regards the non-mandatory requirement given in Annexure - 3, they shall be implemented as per the discretion of the company. However, the disclosures of the adoption/non-adoption of the nonmandatory requirements shall be made in the section on corporate governance of the Annual Report.

Yours faithfully, PRATIP KAR

91

Report of the Committee on Corporate Governance February 8, 2003

Annexture1
Information to be placed before board of directors
1. Annual operating plans and budgets and any updates. 2. Capital budgets and any updates. 3. Quarterly results for the company and its operating divisions or business segments. 4. Minutes of meetings of audit committee and other committees of the board. 5. The information on recruitment and remuneration of senior officers just below the board level, including appointment or removal of Chief Financial Officer and the Company Secretary. 6. Show cause, demand, prosecution notices and penalty notices which are materially important 7. Fatal or serious accidents, dangerous occurrences, any material effluent or pollution problems. 8. Any material default in financial obligations to and by the company, or substantial non-payment for goods sold by the company. 9. Any issue, which involves possible public or product liability claims of substantial nature, including any judgment or order which, may have passed strictures on the conduct of the company or taken an adverse view regarding another enterprise that can have negative implications on the company. 10. Details of any joint venture or collaboration agreement. 11. Transactions that involve substantial payment towards goodwill, brand equity, or intellectual property. 12. Significant labor problems and their proposed solutions. Any significant development in Human Resources / Industrial Relations front like signing of wage agreement, implementation of Voluntary Retirement Scheme etc. 13. Sale of material nature, of investments, subsidiaries, assets, which is not in normal course of business. 14. Quarterly details of foreign exchange exposures and the steps taken by management to limit the risks of adverse exchange rate movement, if material. 15. Non-compliance of any regulatory, statutory nature or listing requirements and shareholders service such as non-payment of dividend, delay in share transfer etc.

92

Annexure 2 Suggested List of Items to Be Included In the Report on Corporate Governance in the Annual Report of Companies
1. A brief statement on companys philosophy on code of governance. 2. Board of Directors: Composition and category of directors for example promoter, executive, non-executive, independent non-executive, nominee director, which institution represented as Lender or as equity investor. Attendance of each director at the BoD meetings and the last AGM. Number of other BoDs or Board Committees he/she is a member or Chairperson of. Number of BoD meetings held, dates on which held. 3. Audit Committee. Brief description of terms of reference Composition, name of members and Chairperson Meetings and attendance during the year 4. Remuneration Committee. Brief description of terms of reference Composition, name of members and Chairperson Attendance during the year Remuneration policy Details of remuneration to all the directors, as per format in main report. 5. Shareholders Committee. Name of non-executive director heading the committee Name and designation of compliance officer Number of shareholders complaints received so far Number not solved to the satisfaction of shareholders Number of pending share transfers 6. General Body meetings. Location and time, where last three AGMs held. Whether special resolutions Were put through postal ballot last year, details of voting pattern. Person who conducted the postal ballot exercise Are proposed to be conducted through postal ballot Procedure for postal ballot 7. Disclosures. Disclosures on materially significant related party transactions i.e. transactions of the company of material nature, with its promoters, the directors or the management, their subsidiaries or relatives etc. that may have potential conflict with the interests of company at large. Details of non-compliance by the company, penalties, and strictures imposed on the company by Stock Exchange or SEBI or any statutory authority, on any matter related to capital markets, during the last three years. 8. Means of communication. Half-yearly report sent to each household of shareholders. Quarterly results 93

 Which newspapers normally published in. Any website, where displayed Whether it also displays official news releases; and The presentations made to institutional investors or to the analysts. Whether MD&A is a part of annual report or not. 9. General Shareholder information AGM : Date, time and venue Financial Calendar Date of Book closure Dividend Payment Date Listing on Stock Exchanges Stock Code Market Price Data : High., Low during each month in last financial year Performance in comparison to broad-based indices such as BSE Sensex, CRISIL index etc. Registrar and Transfer Agents Share Transfer System Distribution of shareholding Dematerialization of shares and liquidity Outstanding GDRs / ADRs / Warrants or any Convertible instruments, conversion date and likely impact on equity Plant Locations Address for correspondence

94

Annexure 3

1. Non-Mandatory Requirements

2.
a) Chairman of the Board A non-executive Chairman should be entitled to maintain a Chairmans office at the companys expense and also allowed reimbursement of expenses incurred in performance of his duties. b) Remuneration Committee i. The board should set up a remuneration committee to determine on their behalf and on behalf of the shareholders with agreed terms of reference, the companys policy on specific remuneration packages for executive directors including pension rights and any compensation payment. ii. To avoid conflicts of interest, the remuneration committee, which would determine the remuneration packages of the executive directors should comprise of at least three directors, all of whom should be non-executive directors, the chairman of committee being an independent director. iii. All the members of the remuneration committee should be present at the meeting. iv. The Chairman of the remuneration committee should be present at the Annual General Meeting, to answer the shareholder queries. However, it would be up to the Chairman to decide who should answer the queries. c) Shareholder Rights 3. The half-yearly declaration of financial performance including summary of the significant events in last six-months, should be sent to each household of shareholders. 4. D) Postal Ballot 5. Currently, although the formality of holding the general meeting is gone through, in actual practice only a small fraction of the shareholders of that company do or can really participate therein. This virtually makes the concept of corporate democracy illusory. It is imperative that this situation which has lasted too long needs an early correction. In this context, for shareholders who are unable to attend the meetings, there should be a requirement which will enable them to vote by postal ballot for key decisions. Some of the critical matters which should be decided by postal ballot are given below: 7. a) Maters relating to alteration in the memorandum of association of the company like changes in name, objects, address of registered office etc; b) Sale of whole or substantially the whole of the undertaking; c) Sale of investments in the companies, where the shareholding or the voting rights of the company exceeds 25%; d) Making a further issue of shares through preferential allotment or private placement basis; e) Corporate restructuring; f) Entering a new business area not germane to the existing business of the company; g) Variation in rights attached to class of securities; h) Matters relating to change in management

95

Notes: a: Antidirector Rights measure how strongly the legal system protects minority shareholders against dominant shareholders in the corporate decision making process, including the voting process. For details, see from La Porta et al. (1998). 1: Data is based on the study sample of 1567 companies. 2. Includes commercial banks, government owned/promoted term-lending institutions and financial corporations. 3. Individuals include top 50. Others include shares held by directors and relatives. Sources: Data on Distribution of Shareholding (i) - (vii) for US, UK, Germany and Japan from OECD, 1995. Data on I (viii), II and III for all five countries pertains to the year 1993 and sourced from La Porta et al. (1998), Table 7 and Table 5.

96

Differences between US GAAP & Indian Accounting Standards

97

Market Capitalization for Top 50 Companies

Company Name Oil & Natural Gas Corporation Ltd. Indian Oil Corporation Ltd. Indian Oil Corporation Ltd. ITC Ltd. Hindustan Lever Ltd. State Bank of India Ranbaxy Laboratories Ltd. Steel Authority of India (SAIL) Ltd. Steel Authority of India (SAIL) Ltd. ICICI Bank Ltd. Bharat Heavy Electricals Ltd. Gas Authority of India Ltd. Wipro Ltd. Tata Engineering & Locomotive Company Ltd. Satyam Computer Services Ltd. HDFC Bank Ltd. Hindustan Petroleum Corporation Ltd. Price 752.00 433.65 433.65 1,155.00 122.25 489.15 1,119.50 43.55 43.55 262.70 594.00 166.80 599.00 415.60 376.00 413.00 329.20 359.00 164.50 164.50 1,147.90 285.70 355.00 985.00 1,260.00 454.30 124.00 153.60 754.65 189.65 346.00 457.45 210.95 535.00 172.90 250.90 275.00 618.00 104.75 550.20 98 Volume (# Market Cap sh.) Rs. bn 13777 1,072.30 89455 337.67 89455 337.67 677 285.88 5327 269.10 25768 257.44 1161 207.61 240311 179.88 240311 179.88 185680 161.04 2649 145.39 1350064 141.05 12762 139.25 2545974 132.90 79620 118.27 3270 116.48 273627 111.71

Infosys Technologies Ltd.

Bharat Petroleum Corporation Ltd. National Aluminium Company Ltd. National Aluminium Company Ltd. Grasim Industries Ltd. TISCO HCL Technologies Ltd. Bajaj Auto Ltd. Hindalco Industries Ltd. Hero Honda Motors Ltd. Mahanagar Telephone Nigam Ltd. Zee Telefilms Ltd. Dr. Reddy's Laboratories Ltd. Bank of Baroda Gujarat Ambuja Cements Ltd. Mahindra & Mahindra Ltd. Indian Petrochemicals Corporation Ltd. Nestle India Ltd. Videsh Sanchar Nigam Ltd. Oriental Bank of Commerce Associated Cement Companies Ltd. GlaxoSmithKline Pharmaceuticals Ltd. Hindustan Zinc Ltd. Bharat Electronics Ltd.

1,654.00 518588
1565 4835 4835 2640 46185 3575 270 895 4271 12151 15314 995 26204 7610 16090 14259 255400 150 7136 10787 25582 10585 0

109.47
107.70 105.99 105.99 105.23 105.07 102.36 99.67 93.82 90.72 78.12 63.36 57.74 56.14 53.70 53.07 52.36 51.58 49.28 48.31 46.99 46.03 44.26 44.02

Container Corporation of India Ltd. Siemens Ltd. Corporation Bank Shipping Corporation of India Ltd. Nicholas Piramal India Ltd. Mangalore Refinery And Petrochemicals Ltd. Bharat Forge Ltd. Lupin Ltd. Digital GlobalSoft Ltd. (Equipments) Source: www.indiainfoline.com

600.00 1,160.10 267.00 135.60 882.00 37.45 785.00 686.80 835.00

1050 0 560 4375 0 209703 5505 11545 6668

38.99 38.44 38.30 38.28 33.52 29.76 29.57 27.57 27.45

Updated On: 12/31/2003

BANKING

Company Name State Bank of India ICICI Bank Ltd. HDFC Bank Ltd. Bank of Baroda Oriental Bank of Commerce Corporation Bank Bank of India Global Trust Bank Ltd.
PETROCHEMICAL

Price Volume (nos) Market Cap (Rs bn) 489.15 25768 257.44 262.70 185680 161.04 413.00 3270 116.48 189.65 26204 56.14 250.90 7136 48.31 267.00 560 38.30 53.40 13875 26.09 1.17 867237 0.14

Updated On : 12/31/2003

Company Name Price Volume (nos) Market Cap (Rs bn) Indian Petrochemicals Corporation Ltd. 210.95 14259 52.36 National Organic Chemical Industries Ltd. 18.45 0 2.26
TELECOM
Updated On : 12/31/2003

Company Name Mahanagar Telephone Nigam Ltd. Videsh Sanchar Nigam Ltd. Finolex Cables Ltd. Sterlite Optical Technologies Ltd. Himachal Futuristic Communications Ltd.

Price Volume (nos) Market Cap (Rs bn) 124.00 12151 78.12 172.90 150 49.28 143.00 550 4.91 60.40 15350 3.38 8.25 4000 1.10

99

AUTO
Updated On : 12/31/2003

Company Name

Price

Volume (nos) 2545974 270 4271 16090 0 0 1571 0 5 0 19847 45701 600 1400 16432 0 0 0 9616

Market Cap (Rs bn) 132.90 99.67 90.72 53.07 11.12 9.25 7.99 5.41 5.38 3.94 3.64 2.27 1.77 1.55 1.48 1.17 1.16 0.89 0.27

Tata Engineering & Locomotive Company 415.60 Ltd. Bajaj Auto Ltd. 985.00 Hero Honda Motors Ltd. 454.30 Mahindra & Mahindra Ltd. 457.45 Punjab Tractors Ltd. 182.95 MRF Ltd. 2,180.00 Apollo Tyres Ltd. 219.95 Exide Industries Ltd. 152.00 Motor Industries Company Ltd. 1,680.00 Bajaj Tempo Ltd. 299.00 SKF Bearings India Ltd. 80.40 Ashok Leyland Ltd. 19.05 LML Ltd. 40.55 Ceat Ltd. 43.95 TVS Motor Company Ltd. 64.00 Swaraj Engines Ltd. 281.65 Goodyear India Ltd. 50.15 Amara Raja Batteries Ltd. 78.00 Kinetic Engineering Ltd. 65.85
CEMENT

Updated On : 12/31/2003

Company Name Grasim Industries Ltd. Gujarat Ambuja Cements Ltd. Associated Cement Companies Ltd. Birla Corporation Ltd. India Cements Ltd. Kesoram Industries Ltd. Kesoram Industries Ltd. Madras Cements Ltd.
ENGG.

Price Volume (nos) Market Cap (Rs bn) 1,147.90 2640 105.23 346.00 7610 53.70 275.00 10787 46.99 125.10 5301 9.63 40.80 8201 5.69 105.90 4250 4.86 105.90 4250 4.86 880.00 0 1.06

Updated On : 12/31/2003

Company Name Bharat Heavy Electricals Ltd. Siemens Ltd. Bharat Forge Ltd. Cummins India Ltd. Alfa Laval (India) Ltd. Crompton Greaves Ltd. Thermax Ltd.

Price Volume (nos) Market Cap (Rs bn) 594.00 2649 145.39 1,160.10 0 38.44 785.00 5505 29.57 121.85 225 24.13 606.20 0 11.03 210.45 0 11.02 430.55 0 10.26 100

Atlas Copco (India) Ltd. Ingersoll-Rand (India) Ltd. Escorts Ltd. Greaves Ltd. Esab India Ltd. Abbott Laboratories (India) Ltd.
IT

636.00 221.65 64.00 76.80 93.50 96.65

0 6849 1100 0 0 595

7.17 7.00 4.62 3.43 1.44 0.50

Updated On : 12/31/2003

Company Name Wipro Ltd. Satyam Computer Services Ltd. Infosys Technologies Ltd. HCL Technologies Ltd. Digital GlobalSoft Ltd. (Equipments) HCL Infosystems Ltd Hughes Software Systems Ltd. Mphasis BFL Ltd. Polaris Software Lab Ltd. Tata Infotech Ltd. NIIT Ltd. GTL Ltd. Tata Elxsi Ltd. Mastek Ltd. Rolta India Ltd. SSI Ltd. Sonata Software Ltd. Kale Consultants Ltd. Silverline Technologies Ltd. Pentamedia Graphics Ltd. DSQ Software Ltd. Soffia Software Ltd.
OIL

Price Volume (nos) Market Cap (Rs bn) 599.00 12762 139.25 376.00 79620 118.27 1,654.00 518588 109.47 355.00 3575 102.36 835.00 6668 27.45 646.40 0 20.63 574.35 0 19.29 480.20 10770 8.23 149.70 10439 7.66 364.55 8989 6.70 162.10 30 6.27 76.55 218974 5.42 156.00 4522 4.86 338.00 1115 4.71 71.75 1775 4.57 185.90 1 2.50 13.62 0 1.43 59.65 0 0.69 3.86 275087 0.65 4.28 407039 0.32 5.81 0 0.27 24.10 4560 0.10

Updated On : 12/31/2003

Company Name Oil & Natural Gas Corporation Ltd. Indian Oil Corporation Ltd. Gas Authority of India Ltd. Hindustan Petroleum Corporation Ltd. Bharat Petroleum Corporation Ltd. Mangalore Refinery And Petrochemicals Ltd. Kochi Refineries Ltd. Chennai Petroleum Corporation Ltd. Gujarat Gas Company Ltd.

Price 752.00 433.65 166.80 329.20 359.00 37.45 175.00 122.15 481.00 101

Volume Market Cap (Rs (nos) bn) 13777 1,072.30 89455 337.67 1350064 141.05 273627 111.71 1565 107.70 209703 216521 139017 100 29.76 24.23 18.22 6.17

PHARMA
Updated On : 12/31/2003

Company Name Price Volume (nos) Market Cap (Rs bn) Ranbaxy Laboratories Ltd. 1,119.50 1161 207.61 Dr. Reddy's Laboratories Ltd. 754.65 995 57.74 GlaxoSmithKline Pharmaceuticals Ltd. 618.00 25582 46.03 Nicholas Piramal India Ltd. 882.00 0 33.52 Lupin Ltd. 686.80 11545 27.57 Sun Pharmaceutical Industries Ltd. 405.05 702 18.95 Aventis Pharma Ltd. 790.00 2312 18.19 Novartis India Ltd. 544.80 0 17.41 Cipla Ltd. 282.20 1000 16.92 Wockhardt Ltd. 342.40 10371 12.42 Pfizer Ltd. 516.75 0 12.11 Burroughs Wellcome (India) Ltd. 863.50 0 7.92 Ipca Laboratories Ltd. 625.00 0 7.81 Knoll Pharmaceuticals Ltd. 442.00 2255 7.16 German Remedies Ltd. 475.00 3026 3.92 Glenmark Pharmaceuticals Ltd. 201.00 19581 2.04 Kopran Ltd. 53.60 2450 0.77
STEEL
Updated On : 12/31/2003

Company Name Steel Authority of India (SAIL) Ltd. TISCO Essar Steel Ltd. Jindal Strips Ltd. Jindal Iron & Steel Co. Ltd.

Price Volume (nos) Market Cap (Rs bn) 43.55 240311 179.88 285.70 46185 105.07 28.55 2334321 9.54 202.75 3327 3.83 192.00 379547 2.48

102