T C A Srinivasa-Raghavan: How promoters rip off shareholders

OKONOMOS

Promoters pay themselves huge sums in diversified firms and shareholders are none the wiser.

A while back, the Prime Minister expressed great displeasure over rich businessmen's tendency to indulge in ostentation. Since he was speaking at a CII function, everyone thought he was chastising these 'captains' of industry.

He is reported to have cautioned that "rising income and wealth inequalities, if not matched by a corresponding rise of incomes across the nation, can lead to social unrest." An industrialist friend "" not a 'captain' by any stretch of imagination and certainly not a member of the boring, idealess old CII "" told me that the good doctor didn't have a clue about managerial pay. He said it is the big boys who were fouling the pond for everyone else.

He said we have perhaps not studied managerial pay in India in the way we should "" calmly and without feeling virtuous in the way the Communists do when they play "let us pretend", which is all the time. I then looked for such research and, to my utter surprise and delight, found a very recent research paper* on the IIM Calcutta website by Manju Jaiswall and Michael Firth. They make a simple point. "There is a need to examine whether statistical relationships and directional causality found between pay and performance for the US settings apply in India which has different ownership structures (the majority are family owned-and-managed firms), governance structures, tax regimes, risk exposure, etc".

The central issue, of course, is how do you decide how much to pay the chaps at the top. It doesn't matter much whether they are family owned (and managed) firms or professionally managed ones. There are many theories, but do they fit India? The authors say "corporate governance compliance is relatively a recent phenomenon in India" and go on to point out that in-house remuneration committees "" aptly referred to by the authors as the 'dummy variable' "" "have a positive role to play."

The authors have based their findings on a survey but the sample appears to have been quite small because not enough people responded. For that reason, say the authors, what they have got is only an illustrative analysis. The key factor in many cases eventually turns out to be intuition. "Corporate pay consultants admit that in reality, the process is more intuitive than methodical." In other words, as one of Govinda's songs goes, Meri marzi.

Marzi is not entirely arbitrary, though. It depends on corporate strategies and competitors policies. "The results lend support to the notion of high top management pay for family firms." That is, the promoters feed first, longest and most at the trough. And lest the Communists break out in a spontaneous song about the virtues of the public sector, let them be reminded: we are talking of costs to company which, in the public sector, are very high given the productivity levels.

That said, perhaps the most important conclusion for this socialist government is that "higher salaries are determined by performance and have not simply resulted from the removal of restrictions on managerial pay or taxation leverages." So before P Chidambaram is persuaded to so something silly in the next Budget "" remember, it will be an election Budget "" he should, at the very least, commission a proper study to find out more.

One interesting nugget, suitably tucked away in a footnote, is that promoter holding in India is around 44 per cent for family firms, compared to 66 per cent in non-family ones. In the 25-50 per cent shareholding category for the pooled sample, 82 per cent of the sampled firms were family firms. This could mean that "owner managers on average have lesser ownership stakes". But this fact is also indicative of what are called agency-cost problems which go hand in hand with diversified shareholdings. This happens primarily because the shareholders in diversified firms know less about what the CEO is up to than in less diversified firms, as we know from all those soaps on TV.

It is, therefore, perfectly rational for promoters to have a diversified ownership structure so that they can rip the shareholders off. If you recall, this is what good old Swaraj Paul was grumbling about back in 1983 when he tried to take over Escorts and DCM. The promoters had less than 12 per cent each.

So, the moral of the story: promoters should be paid for performance, not for their contacts. The Prime Minister should ask the CII to find a way of getting this done.

*Top Management Compensation and Firm Performance in the Emerging Markets: Evidence from India, May 2007 http://www.iimcal.ac.in/res/upd/WPS%20602%20A.pdf