Assessing these parameters is as important as evaluating the financials, earnings potential and valuation of a company
With subscriptions to most of the recent IPOs going through the roof irrespective of the companies’ fundamentals, it is apparent that investor due diligence has taken a back seat.
While liquidity can trump fundamentals in the short-to-medium term, corporate governance is a key factor for long-term sustainability and value-creation of companies. This factor seems to have been disregarded by investors in a few instances, in their craze for listing gains.
Poor corporate governance may become a breeding ground for mis-managment and fraud, and hence should not be ignored.
Corporate governance of a company is the set of principles by which the firm’s management runs the business, and directs and controls the day-to-day operations of the entity.
Assessing corporate governance standards is as important as evaluating the financials, earnings potential and valuation of a company.
Here, we look at few parameters that investors can use to determine the quality of corporate governance of listed entities.
Related party transactions
The transactions of a company with the parties connected to it — such as promoters/key management personnel, holding companies/subsidiaries and associates — may sometimes present a big challenge to corporate governance. These transactions are completely normal and legal, if done on an arm’s-length basis, that is, conducted as if the parties are unrelated.
But if the transactions pose a conflict of interest, it may not be always in the best interest of the company and its shareholders. This assumes significance in case of family-controlled entities, as these companies tend to have higher related party transactions (RPTs) than others.
RPTs can be in the nature of those done in the normal course of business and those that are not required to be done in the normal course of business.
An example of an RPT done in the normal course of business is purchase of raw materials from, or sale of finished products to, the related entities.
Take the example of Petronet LNG. More than 90 per cent of its revenue in FY20 was derived from related parties including promoters such as Bharat Petroleum Corporation, GAIL and Indian Oil Corporation. This doesn’t automatically mean that the corporate governance at Petronet LNG is weak. But it is vital for a shareholder to keep track of changes to RPT agreements as any small change in the pricing will directly impact the revenues of the company and has a higher risk on operations.
An example of RPTs not in the normal course of business is inter-corporate loans given to related entities of promoters. The loans and advances given to support the finance needs of such related parties could be through diversion of funds, and may not be the ideal use of shareholder money. Sterling & Wilson Solar, a solar EPC contractor, extended inter-corporate loans to its promoters — Shapoorji Pallonji group and Khurshed Daruvala. The promoters delayed the payments and are now in the process of selling their assets to repay the company.
One also needs to assess if the rate at which the loans given to the related parties are commensurate with the market rates.Investors also need to tread carefully on the corporate guarantees given by the entity to its related entities.
Promoters can misuse royalty payments — which are charged to the profit and loss account — to earn higher return from the business at the expense of minority shareholders and other stakeholders.
For example, Jubilant FoodWorks, in February 2019, announced the company would pay 0.25 per cent of its consolidated revenue as royalty for the use of the ‘Jubilant’ brand name to a promoter’s group company, Jubilant Enpro. The shareholders raised concerns over the basis on which the royalty will be paid since the company had not been using the brand name ‘Jubilant’. Following this, the firm withdrew the announcement.
Note that as per the Companies Act, RPTs of a specified type or of value exceeding specified limits need shareholders’ approval, passed through a special resolution.
Treatment of minority shareholders
If a promoter of a company has a track record of not treating its minority shareholders fairly, it is a clear sign of weak corporate governance.
For instance, take Vedanta’s delisting offer announcedin May 2020. The holding company — Vedanta Resources — had proposed to acquire all fully paid-up equity shares of the company that are held by public shareholders.
The indicative offer price fixed was ₹87.5 per share. At ₹87.5, the company was valued about 50 per cent less than its book value as on September 30, 2019. It was also lower than the book value of the company as of March 2020, which had fallen significantly owing to the huge impairment of assets in oil and gas, copper, and iron ore business.
It appeared as if the company was taking undue advantage of the market crash in 2020. The offer price was also almost 40 per cent lower than the market valuation of the company just before the impact of Covid-19. Eventually, the delisting attempt failed as the company failed to garner the required number of shares to delist. Now, the holding company has came up with an open offer to buy 17 per cent of the floating shares at ₹235 per share.
Small shareholders can thank the Companies Act for small mercies. As per the Act, the minority shareholders — who don’t have voting or management control over the company — have certain rights they can exercise on unfair treatment by the promoters/management. It includes the right to appoint a small shareholder director by a specified number of small shareholders (those holding shares whose nominal value doesn’t exceed ₹20,000); the right to apply to the National Company Law Tribunal (NCLT) for oppression and mismanagement by the promoters or the management; shareholding rights in case of reconstruction and amalgamation.
Excessive remuneration of a company’s management, which is not in line with the financials of the entity is considered a corporate governance red flag. Some of the factors that investors must assess are: one, is the remuneration commensurate with the growth in profits or operations? Two, is there a component of performance-linked pay? Three, does the person have requisite qualifications? Four, how does the remuneration compare with peer companies?
These questions are more relevant in the Indian context, where, in many cases, promoters also manage the company in an executive capacity.
Hence, there is a need to ensure there are adequate checks and balances on their pay structure and the utilisation of company funds for their personal needs.
For example, in Easy Trip Planners IPO, one of the red flags was the high promoter salary. During FY20, two of the promoters cumulatively drew an annual salary of ₹ 7 crore. This apart, the reimbursement expenses of the promoters were also high at nearly ₹6 crore for the year. The promoters’ salary alone represented 6 per cent of the revenue from operations for FY20. For the nine months ended December 2020, it constituted 12.5 per cent of the revenue from operations.
To give a perspective, take the case of Indian behemoth in the software industry — TCS. For FY20, its CEO took a total compensation (including performance-based incentive) of ₹13 crore that represented just 0.008 per cent of the company’s revenue.
Investors can find these details in the annual report of the companies. As per the Companies Act, 2013, listed companies are required to disclose in the Board’s report, remuneration details of directors/KMP (key managerial personnel), including the ratio of their remuneration to the median remuneration of employees, and affirmation that the remuneration is as per the company’s policy.
Most listed companies make their nomination and remuneration policy — that details the appointment, term, removal, retirement and remuneration of directors, key managerial personnel and senior management — available on their websites.
Transparency in accounting
Good corporate governance by an entity includes timely and accurate reporting of their financials, prepared in accordance with the applicable standards of accounting. Companies with high standards of corporate governance go beyond the levels of disclosure required by regulations. For example, companies in India are not required to disclose balance sheet details all the quarters. But firms such as Infosys and Bharti Airtel have been disclosing summary/details of balance sheet along with quarterly results, as good corporate governance practice .
Poor disclosures may enable managements to fudge books for various reasons including fear of pressure from shareholders when performance is poor, fear of downgrade by credit agencies, and linking of management’s incentives to the company’s operational performance.
In Satyam Computer Services fraud, former founder and CEO Ramalinga Raju painted a rosy picture of the financials to deceive the public. The management inflated revenues and profits, overstated assets, and understated the liabilities. There was excess billing through fake invoices, forged fixed-deposit receipts and non-existent employees.
Similar was the case with Ricoh India, an Indian arm of the Japanese multinational, Ricoh Global. Ricoh India, too, escalated its revenue, and pushed up profits and reserves by fudging accounting entries that were not supported by actual transactions, as per PwC’s forensic audit report.
IL&FS’s accounting scandal has had a ripple effect on the NBFC sector. The group postponed provisioning for bad loans and/or recognition of NPAs in companies such as IL&FS Financial Services. This enabled it to show good profits so that the entities could raise funds from the market. But there came a point when things went out of control due to asset-liability mismatches, and the crisis broke.
An individual investor may find it difficult to trace finely fudged accounts.
But paying attention to the auditor’s report, which may contain a qualified opinion, or sections titled ‘emphasis of matter’ and ‘key audit matters’ in the audit report, may help investors understand the accounting violations, if any.
Accessing the management’s response to the auditor’s qualifications in the annual report or periodical filings may also provide further information
An auditor’s resignation can be another warning signal. In May 2018, fruit juice maker Manpasand Beverages’ statutory auditor Deloitte Haskins & Sells resigned due to lack of coopearttion from the company. In about a year, with other discrepancies over an alleged GST fraud, the company’s second auditor and independent directors, too, tendered their resignations. As of now, the stock of the company stands suspended for trading.