A toast for good governance

It is widely known that a governance premium is levied on companies with good governance. This article examines the factors that determine good governance in detail.

Two main factors significantly impact share valuation:

Promoters’ holding is seen as a key determinant of a firm’s value; the promoters’ equity is a measure of entrepreneurship and capital formation. Promoters in certain situations are seen to resort to manipulative governance practices. Additionally, a high promoters’ stake leaves minority shareholders with little say in the working of the company. Minority shareholders are further impacted if a fraud is exposed in promoter-driven companies — the stock is frozen at lower circuit with only sell orders from investors and no willing buyers.

Moreover, pledging in a declining market can spur a promoter to manipulate stock prices to an artificial level, to maintain margin money or avert a hostile takeover. This could be done through earnings management, falsifying financial information, synchronised trading, or actively disseminating false information.

Pledging of shares: According to the white paper “Taking stock: Playing in the Indian Capital Markets”, released by Thought Arbitrage Research Institute in association with Grant Thornton India LLP (October 19, 2012), pledging of shares seems to have become a norm among promoters in India.

Analysis of BSE 500 companies shows that promoters have pledged shares in about 35 per cent of them. As far as the extent of pledging goes, on an average it's about 30 per cent of the promoters' shares. This average has increased to 35 percent in March 2012. Pledging has also increased in 2009-10 and 2010-11.

The report analysed the shareholding pattern of BSE 200 companies to examine the link, if any, between promoters’ pledged shares and capital market instability. It examined share price volatility with variations in the number of pledged shares (submitted quarterly to BSE) to ascertain if there is a correlation between the two.

It finds that nearly 75 per cent of the companies with pledged shares witnessed volatility greater than 10 per cent, and 80-90 per cent exhibited greater volatility than Sensex. There have been several recent instances of dramatic collapse in share price on disclosure of significant amount of pledging. In such scenarios, financiers sold shares to meet repayment requirements when promoters defaulted.

Indian Promoters

Indian promoters have preferred to hold a significant stake in the companies and are keen to control a majority of the shareholding. Other than dividends and salaries, they have no other source of income. When they need funds they are unwilling to dilute their holdings and prefer to pledge shares to raise money.

In my view, promoters should sell their shares in the market, rather than pledge, to avoid rapid fall in value.

Governance Premium

Robust governance has a premium and it is seen that promoters who demonstrated adherence to corporate governance in spirit have reaped the benefits of governance premium. Suggestions to demonstrate visibly robust governance include:

A strong board which is independent of the promoters; transparent financial reporting and adoption of accounting standards that are conservative and vetted by reputed auditors.

Awhistleblower policy that is led by independent directors who are accessible to not only employees but wider stakeholders including customers, suppliers, shareholders or others.

Establishinga strong Enterprise Wide Risk Management Framework.

Demonstratingthe commitment of top management and board through reasonable and transparent compensation for both.

Rotation independent directors at reasonable frequency.

Ultimately, obtaining the governance premium requires the promoters and management to practise governance in the right spirit and demonstrate it to the external world.

The author is Partner – India Leadership Team, Grant Thornton India LLP