Corporate Governance in India: Has Clause 49 Made a Difference?

In recent years, more and more Indian companies have been raising capital overseas by getting themselves listed on international stock exchanges. These efforts have been accompanied by the Indian government’s drive to attract more foreign direct investment (FDI). Both factors have gone hand in hand with the realization that if Indian companies want more access to global capital markets, they will need to make their operations and financial results more transparent. In other words, they will need to improve their standards of corporate governance.

The Securities and Exchange Board of India, or SEBI, which regulates India’s stock markets, took a major step in this direction a year ago. It asked Indian firms above a certain size to implement Clause 49, a regulation that strengthens the role of independent directors serving on corporate boards. Have these steps made a difference to corporate governance in Indian firms? In the first of a two-part interview, India Knowledge@Wharton spoke about these issues with professors Jitendra Singh and Mike Useem of Wharton’s Management Department who, with their colleague Harbir Singh, are putting together an Executive Education program in Mumbai on Corporate Governance in India.

   

Knowledge@Wharton: A year ago, the Securities and Exchange Board of India began to enforce Clause 49, a regulation that calls for an increase in the number of independent directors serving on the boards of large Indian companies. Recent media reports suggest, however, that though a year has gone by, some 60% of Indian firms have not yet complied with Clause 49. What do you think is going on?

Singh: I am surprised to hear that the number is as low as 60%. When Mike [Useem] and I and Harbir [Singh] were in Mumbai last year, running the last offering of our corporate governance program, one of the concerns we had was how quickly Indian firms would become 100% compliant. It was clear it would take some time.

A couple of issues come to mind. One is factual. The other is my informed speculation. One of the difficulties is there is a finite supply of independent directors. This is a position of great influence; you want people in these roles who will clearly shape the governance of your company. You want people in these roles whom you really trust, who have the right kind of professional qualifications, so naturally you need to be somewhat cautious and thoughtful about whom you bring into the boardroom.

While the numbers that are being bandied around that are quite large, my understanding after talking with various people is, in fact, that the numbers of the right kind of independent directors are not that huge. One might think that leading Indian firms might look to places like the U.S., where in fact, the numbers are significantly larger in terms of supply. Of course, there are all kinds of barriers — India is far away, and as I understand, by Indian regulations, attending by video conference is not counted as board member attendance. Otherwise you will see a lot more Americans — perhaps even people like Mike and Harbir and me — coming on to these boards.

The other subtler thing — and this is partly speculative — is that I suspect it has something to do with just a process of cultural change. There may be some degree of hesitation among companies, as this could mean a certain amount of loss of control — whether it is perceived or real is another matter. I don’t know how true this is, but I suspect it might be going on.

Useem: After the U.S. passed its own version of Clause 49 — or in essence the predecessor of Clause 49 that is the Sarbanes-Oxley Act of 2002 — it has required major changes in how companies are governed and how their auditing functions. That set of regulations, and the regulations put forward by the New York Stock Exchange in 2003, among other things, have required that the audit, compensation and governance committees of our (U.S.) boards of directors be composed entirely of independent directors.

I have been watching U.S. firms come into compliance with the Sarbanes-Oxley Act and the New York Stock Exchange regulations of 2003; it just takes time. Companies have to go through quite significant changes, and my own forecast would be that within some reasonable time, companies in India are going to have to be 100% compliant. Not only are they required to do that, but they should do that, since ample evidence from certainly the U.S. and Europe does reconfirm again and again that the presence of non-executive, independent directors on a board of directors does have an affirmative effect on company performance, especially if a company gets into a bit of trouble, and especially if there is a crisis. Hopefully within a year 100% [of Indian companies] will be compliant [with Clause 49]. That’s going to be a good thing for investors as well as the companies in question.

Singh: I want to endorse what Mike said. Clause 49 is very much aligned with what Sarbanes-Oxley says, but in fact borrows from other regulatory traditions as well. I underscore the point, though, that the evidence that is very clear that Sarbanes-Oxley is, in fact, making a difference in the U.S., as some empirical studies are starting to show up. The other thing is that I have been working the last three years on the board of a New York Stock Exchange-listed company — Fedders Corp. — which is going through some challenging times right now; it’s a turnaround situation. For a medium-sized company to actually comply with Sarbanes-Oxley is fairly demanding. So time is one piece of the argument, the other piece is it does pose demands, even though it is a move in the right direction from the regulatory, governance and investor’s point of view.

Knowledge@Wharton: How do corporate governance standards in India compare to those in other parts of the world? Companies in global industries such as software including Infosys, Wipro, TCS, etc., have taken the lead in setting global standards of governance. Do you see similar moves in other industries?

Singh: The best companies [in India] are very comparable to the best of breed that we see in the U.S. One must also keep in mind, however, that the Indian governance system as it is evolving — while it borrows features from the United States — actually also borrows from other countries. So the emerging frontier of Indian governance in fact is very much comparable to the state of the art across the world.

I would make a distinction between the regulatory aspect and the normative aspect of governance, and differentiate that somewhat from what behavior actually takes place in the boardroom. I do have some experience of boardrooms in India — I have been doing this for the last six or seven years — it seems to me it’s in the realms of behavior that some more catching-up is needed. The norms are in the right place but the change is always compared to where these firms were starting from. That change in behavior will take some time, though the best-governed firms are moving in the direction of normative adherence to the rules and also actual change in behavior in the boardroom.

Useem: In a sense, longer term, Indian companies — especially major Indian publicly listed companies — almost have no choice but to adopt world standards of good corporate governance. In the last 12 months we have seen huge inflows of foreign direct investment — they have doubled in the last 12 months. Private equity coming into India has tripled in the last 12 months. As the providers of foreign direct investment and private equity investment invest in Indian stocks and look at the governance of the firms they are investing in, they bring a mindset of looking at best practices in corporate governance worldwide. They look at the U.S., they look at the U.K. Since everything including equity investing is becoming so much more cross border, Indian companies that are going draw capital or list outside the country — or even those who list inside the country — feel it’s almost a drumbeat to adopt world standards of good corporate governance — that the board should be not too big [and have] 10 to 12 members, independent committees [where] the majority of the directors should be non-executive, and so on.

Companies like Infosys have led the way because they are already in the world market; they are listed outside of India. Many people probably listening to this are investors in Infosys; certainly many Americans are too. The professional, institutional fund holders look at Infosys and make decisions on whether to keep their money in that company or go elsewhere, based on the governance standards it has have adopted. Infosys has led the way, and that’s why there are probably so many international investors in that stock. Other Indian companies in the next five to 10 years are inevitably and unquestionably going to follow suit.

Singh: The point that Mike makes about the relationship between financial markets and foreign funds flows, particularly private equity money, which is broadly within the category of foreign direct investment — this is a very important point. I agree there really is no choice but to adopt these global governance standards. It is important to keep in mind that even as firms like Infosys have really raised India’s flag in a corporate sense on to the world stage very proudly and very successfully — I was privileged for several years to be a board member of Infosys Technologies — there have been firms like those in the Tata Group that have had a tradition of very high quality of governance. But the bottom line is — this is inevitable, this is going to happen, and indeed, as I talk to executives in India, they are more and more accepting of the fact that if you want foreign money to come in, you have to be very open and you have to live up to world standards of governance. The link with foreign capital is a very important one.

The finance minister of India, P. Chidambaram, recently made a statement that India requires about $1.5 trillion in investment in infrastructure. As foreign capital comes in, it actually changes governance or puts pressure for higher levels of governance. Not all of this $1.5 trillion is going to come as foreign capital; some of it will. So imagine what this will do to demands for even better governance. This horse has left the barn and most Indian companies are galloping away, trying to get compliance as soon as possible.

Knowledge@Wharton: In speaking to executives of Indian companies, there is some anecdotal evidence that Indian companies that want to raise capital internationally are seeking to list their firms on stock exchanges in the U.K. or Canada rather than come to the U.S. The reason that is given is the rather onerous burden of Sarbanes-Oxley. Do you see this as a serious issue?

Singh: Just the other day, I was talking with a friend and colleague of mine who is a professor at the University of Toronto. He said he had just taken public a firm where he was the founder from the AIM (Alternative Investments Market) at the London Stock Exchange. This is a Canadian company that is going public in the U.K. This is a midsize company, [where] revenues may be less than $50 million a year. He said they did a very careful analysis of listing in New York, and found the cost of complying with Sarbanes-Oxley would be about $3 million. Now for the firm that has $50 million in revenue, this may be the better part of the profits it is making. So obviously this is a very serious consideration. They went to AIM and that’s where they listed it — and it’s a public company right now.

I believe similar thinking is influencing Indian executives in India. It used to be some kind of a status symbol to come and list in New York. There is no question that Sarbanes-Oxley — certainly for midsize firms — has become somewhat of an obstacle. This doesn’t take away from the point that Mike and I made earlier, that Sarbanes-Oxley is, in fact, doing good things for the investor community. Nevertheless, it has a cost.

Now, in all fairness, there are some very serious conversations taking place within the U.S. and this may lead to results sooner rather than later — where the SEC is itself saying that it may need to change some of the provisions of Sarbanes-Oxley.

Useem: The essence of Sarbanes-Oxley, the essence of Clause 49, is to help companies do what is pretty obvious once we say it. We want companies to provide transparency; we want companies to provide reliable data to those investors who part with their cash, on the assumption that it is going to be well used. The particulars of Sarbanes-Oxley have been much criticized here. We all know there is some effort to revise it, to reduce the relative cost, in particular, on smaller companies.

Research evidence coming in reveals and confirms that Sarbanes-Oxley-compliant firms do benefit, having gone through that very tough internal process of scrubbing all the figures, and making certain all the right data get to investors. Over time, that should lead to a higher stock price. Or a lower cost of capital — a different way to put that. The problem is there are different jurisdictions for listing. You could list in London, Hong Kong, Tokyo or in the U.S., but what we all want to see is a levelingup, and not a playing down. And so if it’s easier right now to list somewhere else, that is the reality. We would hope that all exchanges do put in very acceptable but tough standards for transparency and reliability.

Looking again out five or10 years, this is going to be a world that is defined by the highest level of transparency and reliability as requirements. Sarbanes-Oxley may have led the charge, but the world is moving, roughly speaking, in this direction.

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