This is a Guest Post by Aditya Jaiswal, Analyst at Moody’s Analytics. Passionate blogger and YouTuber. Blogs at www.theastuteinvestor.in
Never, ever, think about something else when you should be thinking about the power of incentives.”— Charlie Munger
It has been twenty-eight years since the 1991 reforms which ended the “License Raj” in India.
Many large corporate groups born as family owned enterprises gradually embraced the wave of transparency and good governance, indicating the fact that clean and well managed companies can succeed in India.
However, 2018 witnessed the opposite end of the corporate spectrum- with major corporate fiascos popping up and Indian promoters making headlines almost every month- IL&FS, TATA Group, ICICI Bank, Manpasand Beverages, Vakranjee, Fortis Healthcare, Infosys, and many more, indicating the fact that the old order has still not completely given way to the new. Contrary to the common wisdom, governance issues are also cropping up in non-promoter led companies such as IL&FS and even MNCs like Ricoh.
Stakeholders place complete faith on the expertise and wisdom of the auditors, independent directors and credit rating agencies. Let us have a look at how these pillars of corporate governance crumbled when it mattered the most.
“Dependent” independent directors
In the merit list of non-performers, independent directors deserve a special place. In the light of the recent cases of alleged fraud and irregularity, it turns out that the independent directors in most cases stay loyal and toe to the promoter’s line, primarily because directors are handpicked by the promoter or the CEOs. Directors also do not challenge the promoters as they do not have skin in the game.
In few cases when independent directors show some spine, they are generally booted out. For instance, in 2016, industrialist Nusli Wadia was removed from the boards of Tata Motors, Tata Steel and Tata Chemicals after he highlighted corporate governance lapses at Tata Sons Ltd. Interestingly, it was the first case in the history of India where promoters had convened an extraordinary general meeting (EGM) to remove an independent director.
In the recent annual meeting of Berkshire Hathaway, even Warren Buffett said this, of independent board members:
They’re just not going to upset the apple cart, because what they’re — and I’d probably behave the same way in the same position. I mean, if $250,000 a year is important to you, why in the hell would you behave in a way that’s going to cause your CEO to say to the next CEO, “This guy acts up a little bit too much. You really better get somebody else.” It’s the way it works.
When going gets tough, the tough go out
In 2018, India witnessed an audit crisis- auditors of over 204 listed firms resigned citing vague reasons such as lack of adequate information and preoccupation with other assignments. The comparable figure for 2016-17 was just 18!
Such an exodus of auditors raises serious questions over the standard of corporate governance in India and also highlights the fact that when the going gets tough, auditors can safely exit with impunity.
Some part of the auditor exit is attributable to tough judgements disallowing certain auditors to perform audit functions for a few more years, because of sins of their past. That a tough action causes you to walk away from certain customers now tells us more about their customers and the auditors’ acceptance of their actions.
Whose bread I eat, his song I sing
Credit rating agencies (CRAs) have also received a fair share of the blame on the back of recent financial frauds. CRAs have repeatedly failed to alert investors about impending defaults be it the case of IL&FS, Zee Group or DHFL. Downgrading bond ratings post default has raised serious questions over the ‘issuer pay model’ wherein CRA’s could develop a mutual understanding with corporates and not act in the best interest of other stakeholders. For instance, SFIO has recently summoned Care Ratings Ltd, ICRA Ltd, India Ratings and Research Pvt Ltd and Brickwork Ratings India Pvt Ltd on their alleged role in rating of IL&FS Financial Services Ltd’s debt papers.
“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. Never a year passes that I don’t get some surprise that pushes my limit a little farther.”- Charlie Munger
Let’s see how the incentives are at work for the pillars of corporate governance.
Let’s have a look at five cases of the recent past, surprisingly, the names include not only smaller companies but even the biggest corporate houses that once held the flag of corporate governance high.
1) The Poster Girl of Good Governance: ICICI Bank
ICICI Bank, India’s leading lender was marred by allegations of corporate misgovernance, nepotism and conflict of interest. The case pertains to a loan of about INR 3,250 crore to Videocon Group in 2012 and involvement of the MD & CEO, Chanda Kochchar’s husband in the process of loan sanctioning. Despite severe allegations, the board of directors allowed Kochar’s presence in the company, worse, even when there was a whistleblower with detailed allegations, the board publicly supported the CEO before an investigation was completed, a brilliant example of how directors toe to the line of celebrity CEOs.
2) India’s Faith in Anything Aam: Manpasand Beverages
SEBI guidelines require all companies (raising funds from public) to disclose if any member of promoter’s family have any interests in competing business, this ensures that investors get to know about any potential issues of conflict of interest. Manpasand Beverages held back an extremely crucial information in it’s draft red herring prospectus (November 2014) about directorial positions held by Promoter’s immediate family members in Hansraj Agro Fresh- a business competitor.
What happened in May 2018 was baffling. After auditing the books of the fruit juice maker for eight years, Deloitte Haskins & Sells resigned just a few days before the finalisation of annual accounts, citing management’s failure to provide significant information- documents supporting the cost, revenue and capital expenditure of the company. Surprisingly, the auditor had given unqualified reports to the company in all the preceding years. The company has denied the allegations but the stock fell 40% in two days and eventually has fallen more than 75% from the peak.
2) The Fallen Angel: Yes Bank
“What is the cost of lies?, it’s not that we will mistake them for the truth. The real danger is that if we hear enough lies, then we no longer recognize the truth”
Yes Bank was growing its loan assets at an impressive CAGR of around 40% (FY15-18) which included relatively riskier segments like developer funding. In 2015, the RBI decided to conduct an asset quality review (AQR) of the balance sheets of the banks. It found out that banks were indulging in account jugglery- they were not fully disclosing their bad loans. At a time when most banks were grappling with rising NPAs, Yes bank’s NPAs were consistently below 2%. In its AQR, RBI found 5.5x more NPA’s in Yes Bank’s books than disclosed by the bank in FY17!
Consequently, Yes Bank has been under RBI’s scanner which led to a series of negative developments. In 2018, RBI pulled up Yes Bank for continuing corporate governance issues, highly irregular credit management practises, and non-compliance of statutory and regulatory rules between FY15-18.
What followed was a spate of resignations by its directors, steep downgrades by Moody’s and ICRA. RBI denied an extension of tenure to the then MD & CEO, Rana Kapoor. Under the new MD, Ravneet Gill, the bank resorted to kitchen sinking in the latest quarterly result and reported a huge loss of INR1500 crores, driven by provisions for its exposure to ADAG group, Essel Group and IL&FS! RBI has now appointed a past RBI board member as a director in Yes Bank, and the stock has fallen to 133 from the highs of Rs. 400 – a 66% fall.
3) Worthy of a standing ovation: Meghmani Organics
In 2007-08, the promoter’s of Meghmani Organics Ltd (MOL), a diversified chemical company, formed another chemical company named, Meghmani Finechem Limited (MFL), where MOL held 57% take, while International Finance Corporation (IFC) and promoters (of Meghmani) owned 24.97% and 18.03%, respectively.
In 2018, IFC wanted to exit from MFL. MOL could have paid the money to IFC and acquired the additional 25% stake in MFL. This would have pushed MOL’s stake to 57%+25% = 82%, approximately.
But as per the promoters, the management of MOL decided they did not want to increase MOL’s stake in MFL beyond the existing figure of 57%.
Therefore, they came up with an extremely complex transaction which resulted in:
- The Listed company (MOL) Paying Rs. 221 cr. to IFC
- In return the listed company gets no ownership of the underlying shares.
- In fact, the shares of IFC somehow go to the promoters themselves, even though the listed company pays the money.
- This subsidiary – MFL – will repay the listed company in a year or so, with 8% return – but as redeemable preference shares. Effectively, a loan to the subsidiary company – but in some magical way, the promoters get a higher stake in the subsidiary company.
The trust was lost, and the stock fell 50% in a short while.
4) All that glitters is not gold: Gitanjali Gems
The case of Gitanjali gems is also an example which raises serious questions on the role of independent directors, auditors and credit rating agencies. Mehul Choksi and nephew Nirav Modi-were allegedly involved in outright fraud amounting to INR13,000-crore. Gitanjali group companies allegedly colluded with PNB officials to secure fraudulent and unauthorised Letter of Undertaking (LoU) and Foreign Letters of Credit (FLCs).
Mehul-Choksi also allegedly siphoned off funds from the company through shell companies. Choksi and Nirav Modi left India and their companies became defunct.Gitanjali’s share fell by over 90% and was ultimately suspended by both NSE and BSE in 2018.
The last case deserves a special cameo in this article as the story is no less than a Bollywood flick.
5) The SME Rockstar: Five Core Electronics
The Indian government in its pursuit of financial inclusion has given a strong push to SMEs, apart from many other facilities, it is also empowering them to get listed on the exchanges. The investor community in its pursuit of the next multibagger, is also keen in owning a pie in the growing SME market.
As a result, 245 SMEs raised over INR 2400 crore through IPOs in 2018. One such company is Five Core Electronics Ltd. The Company’s website claims that it is one of the “top” public address systems (microphones, amplifiers, horns) In India. Its Nov 2018 investors presentation claims that it has presence in 56 countries across 6 continents. It also claims that it’s EBITDA and PAT grew 295% and 426% YoY in 2018. It also boasts of a credit rating of “BBB-” from CRISIL. In May 2018, CRISIL had even revised its outlook from “stable” to “positive” for Five Core’s INR91 Crore bank loans.
Five core filed an IPO in May 2018 to raise INR46 crore. The IPO was a hit with a subscription of 177%! The company even celebrated it’s IPO’s success by throwing a big party.
The story now gets interesting. In March 2019, the company secretary announced his resignation saying that the promoter was absconding. And that there was no activity in the company at all.
Its independent directors are still not able to trace the promoters who have allegedly fled. All key managerial personnel including the MD have resigned. Ironically, its credit rating was valid till Mar 2019.
The stock’s history. The company’s history. And no one seems to know what happened!
So what are we doing about it?
Based on the recently constituted committee under the leadership of Uday Kotak, SEBI has implemented some sweeping changes to improve governance standards. Most significant ones include- minimum of six independent directors on board including a women director, listing of competencies of every director. It has also mandated separation of CEO/MD and chairperson for top 500 listed entities by market capitalization (wef April 2020) and the chairperson can no longer be related to the MD or CEO.
If implemented in spirit, this could be a positive step towards separation of professionalism and kinship, ultimately leading to higher independence of the board. This will impact many corporate houses having one person holding dual designations (CMD) including WIPRO (Azim Premji), Reliance Industries (Mukesh Ambani), Raymond Group (Gautam Singhania).
This could help in some way, but in general when the independence of directors is by itself suspect, adding more such directors to the mix is not going to change things.
SEBI has also made it mandatory for companies to disclose the credentials of the auditor, including fees and any material changes in fee structure. Most importantly, auditors and independent directors will have to provide detailed reasons if they resign. Further, some auditors have been banned for a period – Price Waterhouse Cooper was banned for two years for its role in the Satyam fraud, and Deloitte faces a 5 year ban for what it did (or did not do) in the IL&FS situation.
Recent reports suggest that SEBI and RBI are also reviewing the business model of credit rating agencies to prevent ratings shopping and ensuring greater accountability of rating agencies. Proposals such as mandatory dual ratings and transparent bidding process for selection of rating agencies are being considered. Rules which may compel rating agencies to provide detailed explanations in case of sudden downgrades are also being considered.
These are welcoming changes which were long overdue but one has to see how these are implemented because even the best of regulations can fail, if not implemented in letter and spirit.
While there is a long of anger against these issues of corporate governance, there is no enforcement of our laws by the authorities – CBI, SEBI or the courts. Many past frauds, including the NSEL disaster have still not been resolved, and IL&FS proceedings haven’t even begun. Even the big Satyam fraud resulted in convictions and a 7 year sentence to Ramalinga Raju, the promoter, who instantly got bail as well. If there is no long jail term, there will be no deterrent.
So, as investors and participants, we need to be extra careful about governance – every red flag is a danger sign.
At the same time, we know that most companies are managed like family businesses and some of them thrive only because of the family nature. There are, however, lines that cannot be crossed – siphoning or fraud should be unacceptable. The more we put shady promoters in prison, the better our corporate governance will be, but will the authorities oblige?
This is a Guest Post by Aditya Jaiswal, Analyst at Moody’s Analytics. Passionate blogger and YouTuber. Blogs at www.theastuteinvestor.in