In early 2011 we argued that investors needed to worry more about corruption, moving away from the historic attitude that leant towards resigned acceptance that corruption is a “fact of life” in India, a cost of getting things done, of wading through the bureaucracy. The sheer scale and frequency, particularly the 2G license scandal, was different. This went beyond bribery lower down the hierarchy “greasing the wheels”; rather it was upstream corruption distorting fundamental policy and project decisions, causing inefficient capital allocation.
We argued that the mood in India, with such widespread disgust, and corruption eroding confidence in political parties and parliament, represented a tipping point. In the long-term this would be positive, but in the short term is probably meant more volatility.
Wikileaks exposing the cash for votes scandal in the India-US civil nuclear deal acted as a further catalyst, and April saw an unprecedented campaign against corruption take shape, led by Anna Hazare, helping launch the draft Lokpal Bill, aimed at creating an independent and empowered anti-corruption agency. If one believes the old adage “sunlight is the best disinfectant”, then the relentless pursuit of corruption stories in the media is also likely to play an important role.
The extent of public and press outrage represents a real opportunity for change. However, changing such entrenched behaviours will take time (there is already bickering about appointments in the proposed anti-corruption agency). 61% of respondents to a recent KPMG survey thought corruption would remain the same or deteriorate over the next two years.
Over the past nine months the question we repeatedly get asked by institutional investors is “how do we cope with corruption in the meantime”.
Corruption may deter some investors from India entirely, yet corruption’s negative impact on foreign capital flows is not identical across economies. In a country as attractive as India (economic growth, domestic demand, demographics etc), it is a big call for investors to shun it entirely due to corruption, and obviously domestic institutional investors have no choice. Making decisions to shy away from certain sectors is easier – sectors such as Real Estate, Construction and Infrastructure suffer from higher levels of corruption due to the structure of permissions and contracts with multiple parties at multiple layers – environmental clearances, development permission, compliance requirements etc. The World Bank estimates 60-80% of construction projects in developing countries are undertaken without adequate permissions and approvals –leaving huge scope for corruption. For this reason investors can and do choose to avoid Real Estate and Construction.
But the most important decision is the relative one between companies. This is the area where the most specific work can be done and where investors can push for changes. Indian business and industry has to play its role; so far it has been far too complicit in corruption. Corruption is a two way street, it needs a donor as well as a receiver, it is all too easy to blame bureaucrats and politicians, but the businesses that pay bribes are equally to blame. In far too many cases corruption is induced by the private sector. Partly this is a function of regulation in India, as it is overly focused on the bribe taker, therefore not discouraging the payer enough. But this is changing globally, with tough new legislation in both the US (America’s Foreign Corrupt Practices Act will also put the onus on the investor above certain thresholds to have some responsibility for how a company in India is run) and UK, which will impact companies wishing to raise capital and do deals there, and it will change in India.
We as a firm make the link between corruption and bad governance at the corporate level, just as we make the link at the state level – corruption tends to flourish in environments of weak governance, be they the civil service or a corporation. In the long run poor governance and corrupt practices lead to higher volatility, risk, cost of capital and lower performance. For this reason as a firm Espirito Santo (formerly Execution Noble) has an explicit framework that analyzes and rates governance for all companies we cover, across a number of metrics. We assess these issues based on proprietary forensic accounting templates, promoter integrity checks, insider trading checks and analysis of attitude towards minority shareholders.
In this overall drive towards better governance we think there are several areas where reporting and corporate governance can be further improved by Indian companies and regulations, to the benefit of both companies and investors:
Corruption code of conduct: Companies should introduce a clear code of conduct, as well as a reporting and enforcement mechanism for the prevention of corruption. They should explicitly communicate this to investors.
Complex holding structures and related party transactions: Many larger conglomerates have cross-holdings in other businesses and use complex holding structures. This, along with the prevalence of related party transactions is a major problem in India.
Tightening of insider trading rules: Whilst there are clear rules on insider trading, too many companies stick to the letter of the law and no better. Patterns of trading by promoters, management and insiders often surprise us and when we highlight the patterns to institutional investors they don’t like it. Companies need to have clear internal policies that go beyond the bare minimum of what is allowable.
Selective disclosures: While the SEBI insider trading regulations cover the dissemination of price sensitive information, there is still leakage of price sensitive information, including selective disclosures to favoured analysts or market participants, resulting in information asymmetry and undue market advantage for specific market participants. India’s regime would benefit from similar tightening that the US saw in 2000 with the Regulation Fair Disclosure regime, and the UK saw in 2001 under revised Selective Disclosure rules.
Reporting of quarterly results: One area we see several inconsistencies is reporting of quarterly results, where companies have significant leeway on the reporting framework (consolidated results, condensed, segmental revenues, etc.). Too many companies report quarterly numbers only on a stand-alone basis, which is a convenient way to exclude poorly performing segments.
Consistency in reporting times: The lack of consistent reporting times frequently leads to market advantage for selected participants. It makes no sense that some companies have a habit of reporting results on weekends, particularly when results are perceived to be below market expectations, while there are several companies which prefer to wait until the last day to report their results. In many cases, we have also found a significant time lag between audited results and annual reports, raising suspicions of implicit restatements in annual reports.
Reporting of quarterly balance sheet and cash flows: Apart from smaller companies, even many larger companies, including Nifty-50 companies, do not report balance sheet and cash flows on a quarterly basis. This makes it difficult to assess the evolving balance sheet situation, particularly for companies that have significant capex plans, high leverage or suffer from poor working capital conversion.
Corruption is here to stay as an issue. The frenzy created by the press means it is high on the agenda of every major investor in India. Investors who apply a rigorous framework to analyzing governance, corporate corruption and accounting standards can reduce volatility and risk, and increase long term returns. Investors can also drive improvements through taking a more active stance; pressing management in meetings, participating in AGMs, using voting rights etc. Those companies that recognize the importance of this overall issue can achieve a sustainable premium rating if they demonstrate class leading performance in anti-corruption, corporate governance and transparency of disclosure.
Nick Paulson-Ellis is country head, India for Espirito Santo Securities (formerly Execution Noble).