Watch out, small caps

The corporate governance mishaps that have surfaced in the last few years have been all the top names of the corporate world: Enron, Arthur Andersen, Tyco, WorldCom, Marconi, Vivendi-Universal. Each was an icon in its field. Their top executives had become legends in their lifetime.

Yet, corporate governance is a much bigger issue with companies that have small market capitalisation. To put it differently, companies that are away from the public gaze could be more vulnerable to manipulation. What is more, an army of owner-managers know it and do their utmost to keep their market capitalisation low. So argues Lalita Som in her book, Stock Market Capitalization and Corporate Governance.

The building blocks of Som's argument are simple. In India, companies have chosen to raise debt from banks and financial institutions to fund their business plans rather than raise money from the stock markets.

The reason is obvious. In the not-too-distant past, banks and financial institutions were under the thumb of the government and not averse to giving out loans without carrying out sufficient due diligence on favoured borrowers. More important, the lenders would not ask uncomfortable questions related to corporate governance or even financial impropriety. If they did, political pressure could always be applied to shut them up.

As a result, banks and financial institutions became a convenient source of funds at the cost of probity. Even otherwise, enforcement of corporate governance norms by lenders has seldom worked anywhere in the world. The fallout of the long recession in Japan and several bankruptcies in the Far East go to prove that banks and financial institutions are not able to subject borrower companies to sufficient checks and balances.

Companies, Som goes on to say, have even devised a strategy to keep their market capitalisation low: hand out low dividends and let the cash accumulate on the company's books. This ensures that large investors stay away from these companies and the owner-managers can do whatever they like.

Som's logic is impeccable. The country's stock exchanges are littered with small companies with low market capitalisation. Of the several thousands of listed companies, less than 250 account for the bulk of the daily transaction on the country's top stock exchanges. Since the rest of the stocks are not on the radar screen of large investors, private equity funds or foreign institutional investors, there is little to encourage the prudential adherence to corporate governance norms.

This is important because a substantial amount of wealth is locked in these stocks. A vast majority of these companies went public when the stock markets were not as mature as today. In the early 1990s, for instance, the mutual fund industry was still in a nascent stage and investors chose to dabble in the market on their own. Most readers would remember the NBFC, aquaculture and plantations frenzy of the last decade when a plethora of companies raised money from the public. Most of these investors don't have a clue about what is going on in the companies they put their money in.

But does the presence of large institutional investors, including global funds, necessarily mean better due diligence? Is it very difficult to pull wool over their eyes? By and large, yes, though the same investors have shown a tendency towards mob mentality in the recent past. During the dotcom boom, a large number of fund managers made the mistake of making investments that went bust. Private equity deals were finalised in less than a day. But things have moved on since then. The presence of large institutional shareholders does give added comfort to the smaller shareholders.

One solution to the problem, as suggested by Som, is to let there be more mergers and acquisitions so as to create fewer listed companies but with larger market capitalisation. But, as the author mentions, the investment climate in the country does not lend itself to easy and frequent mergers and acquisitions, least of all hostile takeovers.

But even if it did, what would be the end result? Consolidation in any industry is driven by economic value addition. In some cases, there could be no such value addition.

The other option is strict enforcement of norms by the stock market regulator. Indeed, the new corporate governance norms put in place by the Securities Exchange Board of India (SEBI) stem to a very large measure from the need to monitor these small capitalisation companies.

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STOCK MARKET CAPITALIZATION AND CORPORATE GOVERNANCE

Lalita Som
Oxford University Press
Price: Rs 595; Pages: 247