We have looked at the seven stakeholders such as Shareholders, Bondholders, Employees, Customers, Suppliers, Government, and Society.

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1 Institutional Investors and Corporate Governance in India Pitabas Mohanty * Do the institutional investors (IIs) have a role in the corporate governance (CG) of a company? Most of the reports on CG have emphasized the role the IIs can play in CG. The Cadbury Committee (1992), for example, states: because of their collective stake, we look to the institutions in particular, with the backing of the Institutional Shareholders Committee, to use their influence as owners to ensure that the companies in which they have invested comply with the code (para 6.16). The Kumar Mangalam Birla Committee similarly states: Given the weight of their votes, the institutional shareholders can effectively use their powers to influence the standards of CG. Contrary to this, some argue that the investment objectives and the compensation system in the institutional investing companies often discourage their active participation in the CG. Drucker (1976) has once commented that...it is their job to invest the beneficiaries money in the most profitable investment. They have no business trying to manage. If they do not like a company or its management, their duty is to sell the stock... Corporate Governance Index We first make an attempt to understand the financial performance of the companies with good and poor CG records 1. In most of the work on CG, a measure of financial performance (like Tobin s Q) is usually used as a proxy for CG. However, we have developed a new measure of CG and then made an attempt to understand the relationship of this CG measure with some financial performance measures. Different people define CG differently. Some define it in terms of a formal system where the management is accountable only to the shareholders. Others discuss the responsibility of the management to the entire society. In this paper we have adopted the definition from the SEBI committee report namely, the fundamental objective of CG is the enhancement of shareholders value keeping in view the interests of other shareholders 2 We have looked at the seven stakeholders such as Shareholders, Bondholders, Employees, Customers, Suppliers, Government, and Society. If the Professor, T. A. Pai Management Institute, Manipal. The author gratefully acknowledges the research grant obtained from National Stock Exchange of India Limited. The views expressed and the approach suggested in this paper are of the author and not necessarily of NSE. 1 If we find that institutional stake and financial performance are not related, then we cannot blame the IIs for having ignored CG issues. However, if we find a positive association between stake and performance, then we can no longer ignore CG issues while analyzing the performance of the IIs. 2 To begin with, we make a distinction between the objective of financial management and CG. While the former is all about the responsibility of the company to the shareholders; the latter is also concerned about the other stakeholders.

2 company has got appropriate CG practices in place, it must get reflected in how the company deals with these stakeholders. Thus, for example, if a company has got a good CG system, it would ensure that the company does not evade the payment of excise duties or corporate income tax to the government. The behavior of the company with respect to the above stakeholders can take any of the following three forms: Positive Form: The company takes extra care (more than legally necessary) of the stakeholders. Here a company is not required to take this extra care. But it does it nevertheless to show that it cares. Neutral Form: The company does exactly what is legally necessary while dealing with the stakeholders. Negative Form: The company either does not perform the basic minimum things it is supposed to do legally or tries to avoid the responsibility (though sometimes this behavior is not illegal). The key feature of the negative form is that some of the stakeholders get hurt while dealing with the company, either directly or indirectly. From different sources (web sites of companies, IBID database, Prowess database, etc.) we collected data on all the 19 3 measures for all the companies. While collecting data, we faced two problems. For most of the companies, we did not get any data on some of the measures that we had identified. The second problem related to the number of news clippings that we found for each measure for a company. We do not have any unequivocal answer to these questions. We, therefore, decided to solve these two problems in the following manner. In the preliminary analysis, we decided to exclude all the companies from our sample for which we did not get any information on all the 19 measures. This reduced our sample size to 113. Whenever we get two (or multiple) news clippings for a company, we treat it as one if they are all of the positive form or negative form. However, if we get multiple news clippings with some having positive form while the others having negative form, then we treat it as a negative form. 3 There are actually twenty-one measures (three forms for seven stakeholders). We however ignore the positiveforms for government and suppliers.

3 Initially we started with all non-finance companies 4 for which the relevant data are available in the Prowess database as on 31 March We collected data on institutional stake holding on this date. Data regarding the stock prices and the accounting variables were also sourced from the Prowess database. One of the objectives of this paper is to see if the different CG measures are related to the financial performance of the companies. However since we identified nineteen measures of CG, it becomes difficult to relate each one of them to the financial performance of the companies. We, therefore, decided to form one CG index based on these 19 measures. In this paper we decided to give unequal weights to the 19 measures. In particular, we decided to give higher weightage to the governance measures relating to the shareholders compared to the other stakeholders. Secondly, we have given a higher negative weight (in absolute values) to the negative-form measures as compared to the positive form measures. Table 1 explains the weights assigned to the 19 measures. Table 1: Weights for Different Measures of CG Stakeholders Positive Form Neutral Form Negative Form Shareholders Bondholders Employees Customers Suppliers NA 0-3 Government NA 0-3 Society Then we compute the CG index for all the 113 companies. This is a mere summation of all the weights for the respective measure. We do agree that this method of computing the CG index is not full proof and that one will get a different index (and hence probably different conclusions) if 4 We exclude finance companies because there are separate regulatory bodies to monitor the activities of the finance companies. Thus we do not study the CG practices at the institutional investing companies.

4 one changes the weights of the 19 measures or if one decides to use different measures for that matter. CG Index and Financial Performance We make an attempt to find out the financial performance of these 113 companies. This is a direct test of our hypothesis that there is no relationship between CG practices and financial performance. We use Tobin s Q and stock returns as the measures of financial performance. We define Tobin s Q as the sum of market value of equity and book value of debt divided by the book value of total assets 5. Table 2 compares the CG index with the financial performance measures that we have identified here. Here, stock return is actually the excess stock return. This is computed as the difference between the actual return and the median return of the stocks in the same industry. We divide the 113 companies into five quintiles based on their score in the CG index. Table 2: CG Index and Financial Performance CG Index (Median for the Quintile) Median Tobin s Q Median Excess Stock Returns (%) Certain interesting conclusions can be drawn from Table 2. There is a positive relationship between CG index and financial performance measured in terms of Tobin s Q and excess stock returns. This implies that companies with better CG records have generated higher returns for their investors. CG Index and Institutional Investors In India, there are broadly four types of IIs. The developmental financial institutions, like IFCI, ICICI, IDBI, the State Financial Corporations, etc form the first category. The second category covers all the insurance companies like the Life Insurance Corporation (LIC), General Insurance Corporation (GIC), and their subsidiaries. The third category includes all the banks. Finally, in the last category, all mutual funds (MFs), including UTI, are included. We also attempt to link the CG index with the stakes of the IIs. We have included both the debt and equity investments made by the IIs. We define debt investments as the percentage of total 5 In financial economics, we divide the market value of the company with the replacement costs of the assets and not the book value of the assets to compute Tobin s Q. However Indian companies do not report the replacement costs of the assets and hence we use the book value of the assets as a proxy for the replacement cost of the assets.

5 borrowings financed through a particular source. Subsequently we make an attempt to understand the institutional ownership pattern in the above 113 companies. As before, we make an attempt to understand the median ownership stake of these IIs in the five quintiles. Table 3 reports the institutional shareholding pattern in the first and the last quintile only. Table 3: Shareholding Pattern in the First and the Last Quintile CG Index Quintiles Institutional Ownership Q 1 (Best CG records) IFCI (0.89%) ICICI (1.89%) IDBI (1.16%) UTI (0.56%) MFs (6.89%) LIC (0.74%) GIC (1.1%) Banks (0.59%) Debts by FIs (6.41%) All of the above (2.4%) Q5 (Poor CG records) IFCI (0.9%) ICICI (2.01%) IDBI (1.21%) UTI (3.21%) MFs (2.14%) LIC (0.9%) GIC (0.89%) Banks (3.21%) Debts by FIs (4.45%) All of the above (2.61%) Note: Figures in brackets indicate Median Stake. From Table 3, we obtain certain interesting results. There is a positive relationship between the stake of MFs and CG index. There is also a positive relationship between the debt holding of the DFIs and CG index. There is a negative relationship between the stake by the banks (both debt and equity) and CG index. There is also a negative relationship between the stake of UTI and CG index. This shows that the performance of UTI is totally different from that of the other MFs. Institutional Investors and Financial Performance We redefine CG using a narrow perspective by looking only at the shareholders. This allows us to increase the sample size considerably as we get all the required data from the Prowess database.

6 There is also another reason why we feel confident about taking a narrow perspective on the subject. Our analysis in the previous section shows that companies with good governance practices have in fact developed superior stock returns. Their Tobin s Q is also the highest. One can therefore look at Tobin s Q as a proxy for the CG index developed in the previous section. In this section we attempt to find out if there is a link between CG (Tobin s Q as a proxy) and the stakes of the IIs. In any analysis on CG, one must keep in mind the possibility that the effect of stake on corporate performance is a two-way traffic. It is possible that there is a positive relationship between CG and IIs stakes because the IIs actively monitor the performance of the companies. It is also possible that the IIs have merely invested in the companies with good performance. Therefore, any attempt to understand the relationship between stake and financial performance will not be complete unless one accounts for both these effects. Following Bhojraj and Sengupta (2001), we have used simultaneous equation method to understand the relationship between stake and performance. We have run the following system of simultaneous equations for each category of II. We have shown the system for the non-uti MFs only. We use a similar system for the other IIs. TQ = a 0 + a 1* STAKE-UTI + a2*stake-omf 6 + a3*stake-icici + a4*stake-idbi + a5*stake-ifci + a6*stake-lic + a7*stake-gic + a8*stake_fi_debt + a9*bank- EQUITY + a10*bank-debt + a11 *PBV + a12*size + a13 * BETA + a14 *AGE + error terms STAKE-OMF= b 0 + b 1 *TQ + b 2 *SIZE + b 3 *AGE + b 4 *LIQUIDITY + error terms We use two-stage least square method to estimate the parameters in the above system of simultaneous equations. Table 4 gives the details for UTI and other mutual funds. We have not reported the findings for the other IIs, which indicate similar findings. Table 4: Output of the Simultaneous Equation System Variable TQ Stake-OMF Intercept 0.65 ** 0.1* STAKE-UTI STAKE-OMF OMF stands for the other mutual funds.

7 STAKE-ICICI STAKE-IDBI STAKE-IFCI STAKE-LIC STAKE-GIC STAKE_FI_DEBT 0.32** BANK-EQUITY -0.09* Bank-Debt TQ 0.24** Size 0.04* 0.01 PBV 0.14** 0.3** Beta Age Liquidity 0.04** Note: * means the variable is significant at 5% level. ** means it is significant at 1% level. We derive two interesting conclusions from the above study.

8 There is a positive relationship between the stake of MFs and financial performance. However, this relationship is one-way only, in the sense that it is financial performance that is determining the stake of the MFs in the companies and not the other way round. We find in our previous section that there is a high relationship between CG index and the stake of the MFs in the companies. However, using a system of simultaneous equations we find that this result is due to the fact that the MFs have preferred to invest in companies with better CG index and hence better financial performance. There is a positive relationship between the debt extended by the development financial institutions and the financial performance of the companies. We have not reported this result here. This is quite consistent with what we obtain in the previous section. This shows that the development financial institutions have lent money to companies with better CG index. It also implies that the development financial institutions' lending money has improved the performance of the companies. Feedback from the Institutional Investors We made an attempt to get the feedback from the IIs on the above findings. In particular, we attempted to find out: Whether the IIs study the past CG practices of the companies before making any investments; What actions the IIs take when they come to know of some irregularity within the company. Almost everybody agreed that the development financial institutions usually do not do anything as far as corporate misgovernance is concerned 7. They act only in extreme cases, like for example, they became active when Essar Oil was about to default on its foreign borrowings. Fund managers from the MFs told that the objective of a MF is to earn enough returns for the unit holders and not to look at the CG records of a company. As far as the financial institutions are concerned, three reasons are extended as to why they have such pathetic CG records 8. Firstly, the financial institutions, due to political pressure, usually support the existing management. They become active only in extreme cases. Secondly, they have stakes in many companies. But they do not have enough senior people who can play the role of active directors in the board of the companies 9. Finally, there is no incentive for CG. The nominee directors do not get any reward for active interference. Nor do they get penalized for poor CG practices. 7 We however find that there is a positive association between DFI debt holding and CG. 8 Almost everybody agreed that the financial institutions, though in a position to influence the CG practices of the companies, do not do anything. 9 Sometimes retired bureaucrats are appointed as nominee directors.

9 Some of the fund managers from the MFs say that they look at CG practices before making any investments. However, it is not a prime consideration. What matters is the return that the stock is generating and not the CG practices followed by the company. One of the fund managers, for example told me " 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." Conclusion It is important to understand that corporate misgovernance is not the fault of the IIs who have invested in the companies. However, in view of their large stake in these companies, it is expected that they should play an important role in the CG system of the company. Some people argue that the IIs are answerable to their investors in the very same way the companies are answerable to their investors. Therefore, the primary objective of the IIs should be to maximize the wealth of their own shareholders rather than looking at the CG practices of the companies in which they have invested. We find that companies with good CG records have actually performed better compared to companies with poor governance records. This therefore strengthens the argument put forth by most CG reports that the IIs must be more active while monitoring the performance of the companies in which they have invested. This helps them not only in meeting their investment objectives (in increasing shareholders wealth), but also in doing something socially useful. We also find that IIs have extended loans to companies with good governance records. However we find that there is no effect of the investment of the IIs on the CG records of the companies. References 1. Bjojraj, S., and P Sengupta, 2001, Effect of Corporate Governance on Bond ratings and Yields: The role of Institutional Investors and Outside Directors, SSRN.com. 2. Cadbury, A., Report of the committee on the financial aspects of corporate governance London. 3. Drucker, P F., The unseen revolution: How pension fund socialism came to America Heinemann London. 4. Sarcar, J., and S Sarcar, 2000, Large Shareholder Activism in Corporate Governance in Developing Countries: Evidence from India, International Review of Finance, September, Sengupta, P., 1998, Corporate Disclosure Quality and the cost of debt, The Accounting Review 73 October,

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