SSRN Id1899512

OxfordStudent
LegalResearchPaperSeries
Papernumber04/2011(August2011)
CorporateGovernanceinIndia:
TowardsaMoreHolisticApproach
HARIBHARDWAJ
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CORPORATE GOVERNANCE IN INDIA:

TOWARDS A MORE HOLISTIC APPROACH
Hari Bhardwaj *
Abstract
In this paper, we offer a holistic approach to the development of corporate
governance solutions in India that takes into account the unique economic, political
and structural problems affecting the country. Based on a review of the patterns of
ownership and control of its firms, we identify that the core economic problem
affecting corporate governance in this country today is not the threat that managers
act opportunistically against owners, as is prevalent in the Anglo-American world,
but the threat that majority shareholders act opportunistically against minority
shareholders, thus calling for a new approach to address the Indian context. In
developing this approach, we are mindful of the transplant effect that recognizes
that solutions adopted from outsider jurisdictions are unlikely to be effective in
insider jurisdictions such as India since they address a different agency problem.
We then identify limitations in the institutions of public enforcement in India and
draw upon the political approach to corporate law to conclude that these structural
constraints are likely to continue in the short term, thus limiting the effectiveness of
purely legalistic solutions in the country. We thereafter develop criteria that enable
us to arrive at potential market-based self-enforcing solutions to our core
corporate governance problem.
* BA LLB (Hons.), National Law School of India University; MSc (Law and Finance), University of
Oxford. This paper is the outcome of work that I carried out under the supervision of John Armour at
the University of Oxford and I wish to thank him for his guidance. I would also like to thank Vidya
Rangan. I consider this paper a work in progress and would be grateful for any comments at
haribhardwaj@gmail.com. I alone am responsible for errors or omissions.
Oxford, United Kingdom, June 2011
Corporate Governance in India: Towards a More Holistic Approach!
1!
Table of Contents!
Introduction................................................................................................................. 2
1 Corporate Law and Corporate Governance ...................................................... 5
1.1 The Goals of Corporate Law................................................................................ 5
1.2 Corporate Governance ......................................................................................... 5
2 Setting the Indian Context ................................................................................... 9
2.1 A Brief History of the Corporate Enterprise in India........................................... 9
2.2 Ownership and Control in India......................................................................... 12
2.2.1 Who owns public listed companies in India? ............................................. 12
2.3 Pinning down the Core Corporate Governance Problem in India................... 17
2.4 From Intuition to Reality: The Manifestation of the Problem in India.............. 20
3 The Need for Customisation: the Transplant Effect..................................... 22
3.1 The Effectiveness of Laws in India.................................................................... 22
3.2 The Transplant Effect...................................................................................... 24
4
The Need for Enforceability: Politics and Path Dependence in India........ 27
5 Towards Solutions .............................................................................................. 31

5.1 Enforcement Mechanisms: A Typology ............................................................ 31
5.2 Enforcement Mechanisms and Institutional Maturity: Courts and Markets ...... 32
5.3 Honing in on Strategies...................................................................................... 33
5.4 Developing Solutions......................................................................................... 35
5.4.1 Identifying key actors: non-controlling shareholders............................... 35
5.4.2 Who among non-controlling shareholders? ............................................. 37
5.4.3 Criteria to define the utility of potential actors ........................................ 37
5.4.4 Assessing the utility of each group of non-controlling shareholders ......... 38
5.4.5 Identifying solutions .................................................................................... 41
Conclusion ................................................................................................................. 45
Bibliography .............................................................................................................. 48
!
Hari Bhardwaj
June 2011
Please quote only with the authors permission
2!
Introduction
With the rapid growth of the Indian economy over the past decade and the increasing
prominence of its home-grown companies, the question of how to effectively govern
companies in India has acquired increased prominence. To understand why, one does
not have to look beyond the daily headlines: investors falling in and out of love with
corporate India regularly,1 scandals abounding2 and regulators working overtime.
Many committees have been established,3 and, consequently, regulatory measures
introduced4 to address corporate governance issues in India. Although a few studies
have indicated that some of these measures may have brought some improvement
(Black and Khanna, 2007; Dharmapala and Khanna, 2008), the overwhelming feeling
continues to be that companies in India are just not governed effectively enough.
Inextricable from the corporate governance question is the question of the
enforcement of laws: India continues to languish at the bottom of the World Banks
popular enforcement scale (World Bank/IFC, 2011) and, indeed, there seems to be
little hope of improvement.
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
1
For example, while India saw huge investor inflows in 2010, more recently it has seen large
withdrawals of funds from its markets. (Jopson and Bullock, 2011; PTI, 2011).
2
For example, in 2009, a scandal involving an Indian public listed company Satyam Computer
Services Limited received worldwide attention when its Chairman announced that its accounts, which
reflected over a billion US$ in cash assets, had been falsified. More recently, in 2011, a multi-billiondollar telecom scandal involving alleged irregularities in the awarding of 2G spectrum licences in 2008
has dominated newspaper headlines worldwide (Economist, 2011; Lamont and Fontanella-Khan,
2011).!
3
For instance, see the Kumar Mangalam Committee on Corporate Governance (SEBI, 1999); the
Narayana Murthy Committee (SEBI, 2003). More recently, numerous committees on corporate
governance were established by Indian industry and professional bodies following the Satyam scandal
(CII, 2009; ICSI, 2009).
4
These measures have largely been introduced through a clause in the listing agreement required to be
statutorily maintained by public listed companies in India with the stock exchanges on which their
securities are listed, Clause 49 (SEBI, 2000;2004). However, more recently, in 2009, the Government
of India also introduced voluntary guidelines on corporate governance (MCA, 2009).
Hari Bhardwaj
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While developing corporate governance measures for India, inspiration has

often been derived from governance measures implemented in other countries,
particularly the United Kingdom and the United States, often without adequately
considering whether they are likely to be effective in India. While the efficacy of
transplanting Anglo American models of corporate governance to the Indian
context has been questioned (Verma, 1997; Reed, 2002;Varottil, 2009) there has to
date been little research into alternate home-grown forms of corporate governance.
This paper proposes and explores this need for a holistic approach to
understanding and addressing corporate governance in India. It explores the
development of a corporate governance mechanism that takes into account not just
the unique problems that affect corporate governance in India, but one that
emphasizes the importance of making rules enforceable under feasible enforcement
technology.
With these considerations in mind, this paper is structured as follows: In the
first chapter, we explore the goals of corporate law and the rationale for corporate
governance rules, so as to frame the discussion in following chapters. The second
chapter provides an overview of the setting for corporate governance in India: it
considers the nature of firms in India, their ownership patterns and the question of
whether ownership is separate from control. It thereafter proceeds to identify, in this
light, the core problem affecting corporate governance in India, and overviews the
manner in which this problem manifests itself. In the third chapter, we begin by
considering the effectiveness of current law in India in addressing the core corporate
governance problem, and identify the problems with transplanting Anglo American
models in the Indian context. In the fourth chapter, we build on the political
approach to corporate law to establish the need to explore a self enforcing approach
Hari Bhardwaj
June 2011
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to corporate governance in India. In the final chapter, we consider, in light of our

analysis in the previous chapters, building a framework that allows potentially
workable solutions to the core problem.
Given the potential breadth of the subject-matter, limits to the scope of this
enquiry must naturally be established. First, we will restrict ourselves to a discussion
of the governance of public listed companies in India alone. Second, we will discuss
only the governance of companies as going concerns, and not discuss creditors
rights, a problematic, but specialist area of corporate governance. We believe,
however, that despite these restrictions, this paper could contribute effectively to
literature on the topic.
Hari Bhardwaj
June 2011
5!
Corporate Law and Corporate Governance
We begin by briefly dwelling upon two questions: first, of what properly constitutes
the goals of corporate law and, second, of what corporate governance is all about.
1.1
The Goals of Corporate Law
We propose to adopt the goal identified by the authors of the The Anatomy of
Corporate Law (2009), i.e., that corporate law aims to advance the aggregate welfare
of all who are affected by a firms activities including the firms shareholders,
employees, suppliers, and customers, as well as third parties such as local
communities and beneficiaries of the natural (Kraakman et al., 2009: 28). While
there are numerous ways to conceive of how these aims can be achieved, an approach
common in the law and finance literature is that corporate law seeks to do this
through the maximization of shareholder returns (Kraakman et al., 2009). Although
this view is not universally held, we proceed to our next question since the aim of this
thesis, conceptualizing solutions to the problems affecting corporate governance in
the context of a weak enforcement environment in India, remains relevant
irrespective of how we conceive the goals of corporate law.
1.2
Corporate Governance
While there is undoubtedly no shortage of literature around this question, we find it

useful to see corporate governance in its broad economic terms, i.e., as dealing with
the agency problems resulting from the separation of management and finance, and
of ownership and control (Shleifer and Vishny, 1997; Jensen and Meckling, 1976).
To elaborate, briefly, an agency relationship is a contract under which one
person (principal) engages another (agent) to perform a service on her behalf,
which involves delegating the authority to make decisions. If both the principal and
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the agent are rational, i.e., seek to maximize their individual utility; the agent will
not act in the best interest of the principal (Jenson and Meckling, 1976). A principal
therefore has to limit divergences from her interests by establishing incentives for the
agent, monitoring the agent or paying the agent to expend resources (or incur
bonding costs), to guarantee that she will not take certain actions or that the
principal will be compensated if she takes them (ibid).
A firm, in general terms, can be understood as giving rise to three sets of
generic agency problems (Kraakman et al., 2009): the first between the owners of the
firm or its shareholders (as principals) and its managers (as agents); the second
between the non-controlling owners of the firm, or its minority shareholders (as
principals) and its controlling owners, or its majority shareholders (as agents); and the
third between any of the creditors, employees or customers of a firm (as principals)
and its owners or the managers of the firm (as agents).
To elaborate, assuming that the managers of a firm are different from the
shareholders who finance it (or a separation of ownership and control), once the
financiers have put up their funds, they have to rely on the firms management to put
it to its most effective use. The first agency problem, according to Shleifer and
Vishny (1997) has to do with the financiers concern that a firms management may
act in an opportunistic manner vis--vis them in such a situation. For example, if the
firm considers two investments - one with a lower net present value (NPV) that
produces personal benefits to the manager of the firm and a second with a higher
NPV but one that does not produce similar benefits, the manager may choose to
undertake the former project thus leading to an inefficient outcome. Importantly, the
threat of this opportunistic behaviour is seen to reduce the amount of resources that a
financier is willing to put up before she actually invests (or ex ante) to finance the
Hari Bhardwaj
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firm (ibid). In other words, the threat of inefficiency in the allocation of resources in a
firm ex post results in an ex ante inefficiency as investors cut down finance to such
firms (ibid).
Corporate governance can therefore, in economic terms, be most usefully seen
to deal with constraints that managers put on themselves, or that investors put on
managers, ex ante, to reduce the misallocation of resources ex post (Shleifer and
Vishny, 1997). We can see that by incorporating such constraints, financiers (or
owners) of a firm are likely be induced to provide more funds ex ante. Thus, an
effective corporate governance structure would serve to minimise the agency problem
that we discuss above (or the first agency problem), and thereby minimise the loss
in efficiency (ibid).
In the absence of effective corporate governance mechanisms, owners of a
firm may address the first agency problem by concentrating shareholdings, i.e., by
having both a general interest in profit maximization and enough control over the
assets of a firm to have their interest respected (ibid: 754) (or, in other words, by
aligning cash flow and control rights). Importantly, however, there is a cost in
doing so: capital most efficiently used in financing elsewhere may be diverted to, say,
purchasing a controlling stake in firms, and thereby results in a loss in overall
economic efficiency (ibid).
Expanding our analysis, we can however see that corporate governance need
not necessarily relate solely to the conflict between the owners and the financiers that
we discuss above, but could relate to the mechanisms by which any of the other
agency problems, i.e., between the minority shareholders of a firm and its majority
shareholders (or the second agency problem) and between any of the creditors,
employees or customers of a firm and its owners or managers, are alleviated
Hari Bhardwaj
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(Kraakman et al., 2009). Corporate governance can therefore be conceptualised in

broader terms as the set of checks and balances within the corporate structure that
address agency problems and help enhance long term sustainable value for all stake
holders in a company (Monks and Minow, 1995). Such an interpretation enables us to
see how the question of evolving a corporate governance mechanism for any country
would be very closely linked to the question of how its firms are structured who
owns them and to what extent their ownership is separate from management.
We now proceed to examine these very questions in the context of India.
Hari Bhardwaj
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Setting the Indian Context
The conceptual basis for the development of legal and economic theory surrounding
the corporate firm arguably lies in Adolf Berle and Gardiner Means The Modern
Corporate and Private Property (1932) whose exploration of the dispersed nature of
share ownership in the United States established the model of a firm where
management is separate from ownership (or the Berle Means corporation) as the
predominant model in the Anglo-American world. As we have seen earlier, the
agency problems that form the theoretical basis for corporate governance regulation
underlie this very premise. In exploring the issue of corporate governance in India
therefore, the first step is to explore the nature of firm ownership and ask whether
ownership is indeed separate from management. This chapter draws from literature
and relevant data to address this question.
2.1
A Brief History of the Corporate Enterprise in India
To set the context, it is worthwhile to briefly explore the beginnings and

developments of the corporate enterprise and its financing in India.
The corporate enterprise in India is often credited with having its origin in
managing agencies (Goswami, 2002; Reed, 2002; Chakrabarti, 2005), individuals or
business firms that started new companies, contracted with existing companies to
manage their affairs or helped finance them (Reed, 2002). Following Indias
independence in 1947, new businesses were often promoted by leading managing
agencies, with promoters contributing a minimal amount of equity capital and then
raising the balance either through public offerings or from public development
finance institutions established by the state to facilitate the allocation of industrial
credit (or, sometimes, through investment institutions) (ibid).
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During the period following independence, a number of legislative and policy

measures were introduced that went on to significantly influence the ownership,
growth and financing of firms in India: the 1951 Industries (Development and
Regulation) Act which required all industrial units to obtain licenses from the
central government (Goswami, 2002); the 1956 Industrial Policy Resolution that
stipulated a dominant role for the public sector in the economy and specified
industries for which the state would exclusively or increasingly be responsible (ibid);
the Capital Issues (Control) Act that established the Controller of Capital Issues
(CCI) in 1947 which required companies to obtain permission for the issue of
securities and, more importantly, empowered it to determine the prices at which they
could be issued (Reed, 2002; Khanna and Palepu, 2005); and the Foreign Exchange
Regulation Act of 1973 which, in its extreme form, required multinationals operating
in India to reduce their ownership to below 40 per cent and divest the rest to Indian
investors (Khanna and Palepu, 2005).
As a result of these measures, the state exerted a dominant influence over the
establishment and operation of firms in India, with markets playing a smaller role,
when compared with the way firms evolved in the Anglo-American world. Although
the Bombay Stock Exchange (BSE) was established as early as 1875, entrepreneurs
were severely curtailed in their ability to raise capital from stock markets as the
government decided which companies could access the private capital market, in
what volume, and at what prices of shares (Panagariya, 2008). In the absence of a
developed stock market therefore, three central and state development finance
institutions the Industrial Finance Corporation of India (IFCI), the Industrial
Development Bank of India (IDBI) and the Industrial Credit and Investment
Corporation of India (ICICI), and several state financial corporations became the
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June 2011
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main providers of long term credit to companies (Chakrabarti, 2005). Although, in

consequence, these institutions held (and often still hold) large blocks of shares in the
companies that they lent to, their role in monitoring these companies was limited
since they were evaluated on the quantity of their lending and therefore had little
incentive to monitor, and many entrepreneurs enjoyed managerial control with very
little equity investment (ibid).
The modern development of the Indian stock market began with the abolition
of the 1951 Act in 1991 and the establishment of a new market regulator, the
Securities and Exchange Board of India (SEBI) in 1992. As Khanna and Palepu
(2005: 302) succinctly summarise:!
Following the establishment of SEBI, a number of significant capital
market reforms were put in place: new regulations strengthening
corporate disclosure and governance standards, new regulations and
enforcement mechanisms to ensure orderly and fair trading practices
on the countrys stock exchanges, and the opening of the market to
international financial intermediaries. Companies were allowed to
float shares at market prices, rather than at the artificially low prices
dictated by the Controller of Capital Issues. Finally, Indian companies
were also allowed for the first time to list on international stock
exchanges.
The above measures combined with the establishment of an automated
National Stock Exchange in 1994, the introduction of the dematerialization of shares
in 1996 and trade in derivatives, options and futures in the early 2000s and the
relaxation of foreign investment norms from the 1990s to rapidly accelerate the
development of Indian stock markets (Panagariya, 2008). As a result, India today has
a large and active stock market.5
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
5
For example, in 2008, Indian stock markets had a capitalization of 645 billion US$ compared with
11,738 billion US$ in the US and 1,852 billion US$ in the UK. In terms of turnover, the Indian stock
market accounted for 1,050 billion US$ contrasted with 36,467 billion US$ in the USA and 6,484
billion US$ in the UK. Interestingly, India had 4,921 listed companies, more than the UK (2,415) and
marginally less than the US (5,603) (NSE, 2009:4). !
Hari Bhardwaj
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2.2
Ownership and Control in India
Emerging from this history, we can now examine to what extent there is a separation
of ownership and management in corporate firms in India. Since the focus of our
paper is on public listed companies, we will restrict our discussion to such companies
alone.
2.2.1
Who owns public listed companies in India?
Chakrabarti, Megginson and Yadav (2008) drew on data from Prowess, a database
maintained by the Centre for Monitoring the Indian Economy (CMIE), to analyse
ownership patterns among Indias 500 largest companies, comprising about 65% of
the total BSE market capitalization"! According to their analysis, 60% of these
companies accounting for about 65% of the total market value were affiliated with
family business groups while another 11%, accounting for about 22% of total market
capitalization, were wholly or significantly owned by the central government or state
governments. We present their findings below:
Figure 1: Ownership Distribution of 500 largest Indian companies
70%
60%
50%
40%
30%
20%
10%
0%
Group Companies
Government
Enterprises
Number of Companies
Stand Alone
Stand Alone
Companies (Indian) Companies (Foreign)
Market Value
Source: Chakrabarti, Megginson and Yadav, 2008: 60
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Thus their study indicates not just that shareholdings in major Indian
companies are concentrated, but also that state and business groups continue to
dominate their ownership.
Before we proceed with our review of data here, we briefly digress to explain
a term that not only has specific legal significance in India but is also necessary to
ease our understanding of the data reviewed in this paper - the concept of a
promoter. This term is generally understood to mean an individual, a corporate
entity or a government institution that establishes and continues to have effective
control of a business (since promoter-ship can be effectively transferred through a
sale of business) (Chakrabarti, Megginson and Yadav, 2008). In other words,
controlling shareholders holding a substantial number of shares in the company are
treated as promoters in the Indian context (Varottil, 2009).
Returning to the study under discussion, in an attempt to better understand the
nature of control, Chakrabarti, Megginson and Yadav (2008) also classified the types
of shareholding discussed above as being promoter or non-promoter held. We present
their findings overleaf:
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June 2011
14!
Figure 2: Promoter and Non Promoter holdings in Indian listed

companies
Foreign
Institutional
Investors (Non
Promoters) (16%)
Central and State

Government
(Promoters) (15%)
Individuals
(Promoters) (6%)
Foreign
Promoters
(7%)
Others (4%)
Corporate Entities
(Promoters) (24%)
Individuals (Non
Promoters) (10%)
Indian
Institutional
Investors (Non
promoters) (14%)
Corporate
Entitities (Non
Promoters) (4%)
Source: Chakrabarti, Megginson and Yadav (2008)

Thus, clearly, not only does their study reveal that the state and business
groups dominate the ownership of firms, but also indicates that much of the states
ownership translates into control.
Continuing with our review of ownership data, we also draw upon the data
provided by stock exchanges in India. Firms listed on stock exchanges in India are
required to maintain a listing agreement with the exchanges on which they are listed
under the terms of which, they are required to furnish, on a quarterly and annual
basis, information regarding the legal and beneficial ownership of the securities issue
by them. 6 Based on the information furnished to the National Stock Exchange (NSE),
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
6
This information is to be furnished under Clause 35 of the listing agreement (BSE, n.d.), and covers
the heads set out in Figure 3 (BSE, 2010).
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as of March 31, 2010, the shareholding of 1,470 companies listed on it was

distributed as shown in the chart below (NSE, 2010):
Figure 3: Shareholding Pattern of Companies listed on the National Stock
Exchange of India (2010)
Any Other - Non
Institutional
(3.54%)
Bodies corporate
(5.74%)
Shares against
which depositary
receipts have been
issued (2.31%)
Individuals
(12.03%)
Any Other Institutional

(0.19%)
Venture
Capital Funds
(0.15%)
Foreign
Institutional
Investors
(9.58%)
Indian Promoters
(51.64%)
Financial
Institutions/
Banks/
Government(s)/
Mutual Insurance
Foreign Promoters
Funds Companies
(6.19%)
(3.07%)
(5.57%)
Source: Adapted from NSE (2010)

Thus, we can see that while promoters hold more than 57% of shares of all
companies listed on the NSE, institutional holders hold about 20%, and retail
investors held about 12%. This picture is not very different when examined across
different sectors of the industry either.7 While promoters (Indian and foreign)
holdings range from 73.73% in infrastructure companies to 35.18% in the fast
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
7
The NSE consolidates information provided under Clause 35 and provides shareholding data across
companies in the following sectors: banks, engineering, finance, FMCG, information technology,
infrastructure, manufacturing, media and entertainment, petrochemicals, pharmaceuticals, services and
telecommunication (NSE, 2010).
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moving consumer goods (FMCG) sector, institutional holdings range from 33.17% in
FMCG companies to 13.0% amongst miscellaneous companies and individual
holdings range from 20.84% in engineering companies to 5.87% in infrastructure
companies (ibid).
Based on this limited review therefore, we can see that, generally, with 50%
of shares continuing to be held by promoters, or controlling shareholders, there
continues to be significant concentrated ownership within public listed companies in
India, although it is important to emphasis that this need not necessarily be reflected
in the microcosm of individual companies.8 State and dominant business groups
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
8
For example, Larsen and Toubro, Infosys Technologies Limited and ICICI Bank Limited, all
amongst the largest pubic companies in India are all widely held. Rao and Guha (2006) analyse
changes in the shareholding patterns of 200 large companies pre and post liberalization. The graph
below illustrates how the holdings of the Government, foreign shareholders and corporate bodies in
these companies have changed over these periods. The x-axis shows the range of holdings (with each
colour indicating a different range as shown below), and the y-axis denotes the number of companies
associated with each identified range.
Figure 4: Changes in Shareholding Patterns of 200 Large Companies Pre and Post
Liberalization in India
140
120
100
80
60
40
20
0
Government Government Foreign (pre Foreign (post Corporate
Corporate
(Pre
(Post
liberalization) liberalization)
bodies,
bodies,
liberlization) liberalization)
directors and directors and
relatives (Pre relatives (Post
liberalization) liberalization)
Less than 10%
10% to 25%
25% to 40%
40% to 50%
50% and above
Source: Adapted from Rao and Guha (2006)

Thus, we also strike a note of caution. While it is helpful and correct, to assume that ownership among
public listed companies in India is largely concentrated in developing a model of corporate governance
in India, a single model need not necessary be effective to address all agency problems faced in the
context of individual companies. Multiple patterns of ownership signify the need to maybe adopt
multiple models of corporate governance to address the peculiar kinds of agency problem that each
particular ownership pattern gives rise to. Indeed, if the nature of corporate ownership changes as India
continues down its path of development, we may well require a model of governance that is very
different from we consider in this paper.
Hari Bhardwaj
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appear to continue to wield significant influence while institutional investors (both

domestic and foreign) and retail shareholders are largely restricted to minority
shareholdings. In other words, diffused ownership in the Berle and Means sense is
an exception rather than the rule in India.9 We also see that corporate ownership in
India is not only concentrated, but that the state has had a significant role in defining
the parameters and shape of firms and corporate finance in the country. Even as we
have seen a rapid growth of Indias equity markets and a consequent increase in the
number of shareholders in India over the past few years, historical forces influencing
corporate ownership have been, and are likely, at least in the short term, to continue
to be, influential. In this light, we now characterize the corporate governance problem
in India, in the following section.
2.3
Pinning down the Core Corporate Governance Problem in India
We begin here by revisiting our discussion on corporate governance from the

previous chapter. As we have seen, Shleifer and Vishny (1997) suggest that
concentration of ownership acts as the most direct way to align cash flow and control
rights within a firm and argue that it helps large shareholders address the first agency
problem between the owners of a firm (as principals) and its managers (as agents) by
both having a general interest in profit maximization, and enough control over the
assets of the firm to have their interests respected (p.754). Importantly, however,
they emphasise that this concentration of ownership results in costs as well.
Fundamentally, they make the point that the interests of large investors need not
coincide with the interests of other investors in the firm, or with the interests of
employees or managers (Shleifer and Vishny: 758), and in maximizing her own
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
9
Much of the relevant academic literature supports these conclusions (Varottil, 2009; Khanna and
Palepu, 2005; Reed, 2002; Verma, 1997).
Hari Bhardwaj
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welfare, a large investor can inefficiently redistribute wealth from others (ibid). For
one, they argue, large investors could treat themselves preferentially at the expense of
other investors or employees or force firms to take actions that benefit them to the
exclusion of others, particularly where their control rights are significantly in excess
of their cash flow rights (ibid). Such expropriation, as we have seen, is likely to be
detrimental to efficiency as it would adversely affect the incentives of investors ex
ante (and result in the decline of external finance), or adversely affect the incentives
of managers and employees (and result in them reducing their firm specific human
capital investments) (ibid).
A brief digression becomes necessary to explore what Shleifer and Vishny
mean by separation of control and cash flow rights. The literature points out that
control of a firms operations by a large shareholder with a small direct stake in its
cash flow rights can be, and is, commonly achieved through a variety of means
(Shleifer and Vishny, 1997; La Porta, Lopez-de-Silanes, and Shleifer, 1999; Bebchuk,
Kraakman, and Triantis, 2000; Claessens et al., 2002): first, by organising the
ownership of a firm in a pyramid structure (a simple form of such a structure being
where a controlling (minority) shareholder holds a controlling stake in a holding
company that, in turn, holds a controlling stake in an operating company); second, by
maintaining cross holdings, or having firms own shares in its shareholdings and;
third, by using shares with differential voting rights, such as by attaching all voting
rights to the shares assigned to the controller while attaching no voting rights to the
remaining shares distributed to the public or other shareholders. Separation of control
rights from cash flow rights in the manner described is shown to create higher agency
costs than those associated with a controlling shareholder who has a majority of the
cash flow rights in her corporation (Bebchuk, Kraakman, and Triantis, 2000).
Hari Bhardwaj
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19!
Empirically, there is extensive support for Shleifer and Vishnys views. For
instance, in an influential study, Claessens et al. (2002) show, using data for 1,301
publicly traded corporations in eight East Asian economies, that firm value increases
with cash flow ownership of the largest shareholder, but falls when the control rights
of the largest shareholder exceed its cash flow ownership. This is attributed to the
entrenchment effect of control rights which predicts that as managerial ownership and
control increase, the negative effects of the entrenchment of manager-owners exceeds
the incentive benefits of managerial ownership (Stulz, 1988). 10
Reverting to the Indian context, even where controlling shareholders or

promoters do not own a majority of shares, they are believed to commonly exercise
controlling rights in excess of their economic interests through cross holdings,
pyramid structures and other similar devices (Verma, 1997; Bertrand, Mehta and
Mullainathan, 2002; Chakrabarti, 2005; Varottil, 2009; Afsharipour, 2010). Thus, we
can see that the core Indian corporate governance problem relates to the second
agency problem i.e. the agency problem between non-controlling shareholders (as
principals) and controlling shareholders (as agents), rather than the one between
controlling shareholders and management as is the case in the Anglo-American
world. In short, the core corporate governance problem in India is the threat of
opportunism by controlling shareholders at the expense of non-controlling
shareholders. By identifying this as the core corporate governance problem in India,
we can see right away how adoption of Anglo-American solutions that address a
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
10
Claessens et al. (2002) test two hypotheses in their study. The first is that the more concentrated cash
flow rights are in the hands of the larger shareholder, the stronger is their incentive to have the firm run
properly, and weaker is the incentive to reduce the value of the firm by extracting private benefits. The
second is that the more concentrated control there is, the more entrenched the shareholder is, and the
better able she is to extract value to the detriment of the firms value to minority shareholders.
Hari Bhardwaj
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different problem may be ineffective in the Indian context. Before we proceed to

examine this further however, it remains for us to assess whether this core problem
translates into reality in India.
2.4
From Intuition to Reality: The Manifestation of the Problem in

India
In exploring this empirical question, it is relevant to first enquire what forms the
threat of opportunism against non-controlling shareholders can take. In what is
possibly the most influential law and finance study on the subject, LaPorta et al.
(2000) point out that the expropriation of minority shareholders and creditors by
controlling shareholders can take a variety of forms including the following: stealing
profits; selling outputs of the firm, its assets or additional securities in the firm they
control to another firm they own at below market prices (transfer pricing, asset
stripping and investor dilution, respectively); diverting corporate opportunities from
the firm; installing possibly unqualified family members in managerial positions; or
overpaying executives.
While La Porta et al.s study did not cover India, there is evidence in the
empirical literature of each of the above forms of expropriation in India. For instance,
tunnelling, a form of diversion in which controlling shareholders in a business
group move funds from group firms in which their ownership stakes are low to firms
in which their ownership stakes are high, is believed to be common in India
(Bertrand, Mehta and Mullainathan, 2002; Chakrabarti, Megginson and Yadav,
2008). Further, companies with different categories of controlling shareholders,
whether the state, a foreign parent or Indian business groups, are each seen to be
subject to different forms of expropriation (Verma, 1997).
Hari Bhardwaj
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There is also extensive anecdotal evidence to substantiate expropriation by

controlling shareholders in Indian companies a glance at the headlines of leading
business papers in India, the Economic Times or the Mint would hold this out. For
instance, the scandal involving Satyam became public when, in December 2008,
institutional investors noticed that Satyam tried to acquire two related companies
offering large valuations for both companies with completely unrelated businesses
(Afsharipour, 2010). Almost every week, there are reports of expropriation of
minority shareholders by majority shareholders in India.
We thus see that the problem we have identified does manifest itself in India:
the threat that controlling shareholders of a firm (whether holding a majority of the
control rights, or by holding a disproportionate portion of the cash flow rights) act
opportunistically against its outside investors is seen to play out, and this in turn leads
to minority shareholders demanding a premium for investing. Having established the
core corporate governance problem and evidence of its manifestation in India, we
now proceed to discuss factors that go into addressing this problem.
Hari Bhardwaj
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The Need for Customisation: the Transplant Effect
We realize that the first question that arises upon identifying that a problem exists is
how effective existing laws and regulations are in addressing it. We approach this
question with some trepidation, the reasons being that, first, the question we consider
is an expansive one one that can be the subject of a thesis in itself and just as easily
divert from the mission at hand, and, second, that there is a genuine paucity of
empirical data on this subject in India. We therefore consciously restrict ourselves to
a very brief overview.
3.1
The Effectiveness of Laws in India
We begin here by briefly introducing what is commonly considered to be the first set
of norms introduced to address corporate governance in India - Clause 49.11 Clause
49 was introduced in 2000 pursuant to the recommendations of SEBIs Kumar
Mangalam Committee established to improve the standard of corporate governance in
listed companies (SEBI, 1999). In its initial form, Clause 49 introduced concepts such
as an independent board and a board audit committee (SEBI, 2000; Varottil, 2009). In
2004, Clause 49 was revised significantly following the recommendations of another
SEBI committee - the Narayana Murthy Committee - to require the following in
respect of a listed company (SEBI, 2003; SEBI, 2004): to have a minimum number of
independent directors on its board meeting prescribed standards of independence
(with independence being broadly defined); to have an audit committee of the board
which includes independent directors; to have it periodically make disclosures to
ensure transparency; to have its CEO/ CFO certify the fairness of their financial
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
11
Clause 49 essentially refers to a clause in the listing agreement required to be maintained by a public
company in India with the stock exchange on which its securities are listed under Section 21 of the
Securities (Contracts) Regulation Act, 1956. The format of the listing agreement is prescribed by SEBI
(BSE, n.d.), and is standard across all stock exchanges in India.
Hari Bhardwaj
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statements periodically and accept responsibility for its internal controls, and to
have it state its compliance with corporate governance norms in its annual filings
(Varottil, 2009).
Two influential empirical studies have evaluated the effectiveness of Clause
49 in addressing corporate governance in India. Black and Khanna (2007) report a
positive investor reaction to the introduction of Clause 49 and therefore argue that
properly designed corporate governance mechanisms have a positive impact on firm
value. Dharmapala and Khanna (2008) empirically show that the introduction of
sanctions related to the implementation of Clause 49 have a positive impact of firm
value, of a magnitude higher than in the 2007 study. Thus, both studies indicate that
the measures introduced through Clause 49 have had a positive impact on corporate
governance in India.
When we expand our review however, we find that, notwithstanding Clause 49,
there are still many instances of controlling shareholder opportunism. It has been
argued, separately, that the anecdotal evidence on corporate governance reforms in
India is less promising than the quantitative empirical evidence (Varottil, 2009) and
that paper protection does not translate into actual protection (Chakrabarti,
Megginson and Yadav, 2008;Afsharipour, 2009).
Also, separate from Clause 49, while not usually defined as a corporate
governance measure, under Indian company law, minority shareholders may
approach courts or other authorities to seek relief against oppression and
mismanagement by controlling shareholders. However, there is a high substantive bar
on minority shareholders in initiating such actions, besides severe constraints intrinsic
to the judicial system itself that impair the effectiveness of this mechanism.
Hari Bhardwaj
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To summarise, while there is evidence that the introduction of Clause 49 has

resulted in improved corporate governance, there is still a long way to go. For
instance, while the World Bank ranks India 44th amongst 183 countries under the
category of Investor Protection (based on an anti self dealing index developed by
Djankov et al. (2008) to measure the extent of legal protection of minority
shareholders), the same report ranks India 182nd in the enforcement of contracts,
which perhaps indicates better the extent to which legal rights are actually enforced in
the country (World Bank/IFC, 2011). Second, and more importantly, there appear to
be broader concerns at play about enforceability in India. We consider that in
engaging with this question of developing solutions therefore, the core focus of our
paper, there is a need to investigate further how this enforceability dynamic plays out.
Before we do so, however, we highlight an important consideration that affects the
effectiveness of existing laws in addressing corporate governance problems in India
the transplant effect.
3.2
The Transplant Effect
Varottil (2009) argues that existing corporate governance norms in India, having been
transplanted from jurisdictions such as the US and the UK, are not suitable for
addressing its corporate governance problems. The basis for his argument is that
jurisdictions such as the US and the UK follow the outsider model of corporate
governance whereas, India, as we have seen, follows the insider model. He argues
that dominant shareholders in insider jurisdictions achieve control rights in excess
of their economic interests through tools such as cross holdings and pyramid
structures, and by doing so, are able to exercise complete control. Varottil relies on
the example of the introduction and empowerment of independent directors, seen
globally as a panacea to corporate governance in recent times, to show why AngloHari Bhardwaj
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American models of corporate governance are not likely to be effective.
12
Although
such regulation (premised on addressing the agency problem between managers and
shareholders) may require independent directors to act in the general interests of the
company and the shareholder body as a whole, in an insider jurisdiction
independent directors are de facto likely to owe their allegiance to the controlling
shareholders (who are at liberty to appoint and replace them at will through the
shareholders meeting), and may have the tendency to passively approve their actions.
Thus, according to Varottil, the fundamental purpose of corporate governance in
India, that of addressing the agency problem between the controlling shareholders
and the minority shareholders, is defeated at its very source.13
We find this argument, consistent with our analysis thus far, extremely
convincing. Varottil is not alone in his views although he perhaps articulates it best.
Banaji and Mody (2001) specifically emphasise that the Anglo-American model
which assumes separation of ownership and control is applied in India with little
emphasis on different treatment of different groups of shareholders. Verma (1997)
argues that regulators in India address the wrong agency problems. Others do so as
well, not just in India but also in the context of other jurisdictions with concentrated
holdings. 14
In exploring legal solutions therefore, potential solutions need to be
customised for India inasmuch as the second agency problem, or the conflict
between the controlling shareholder and the minority shareholder should be
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
12
Indeed, as we have seen, Clause 49 is dominated by such measures (SEBI 2004).
13
Varottil acknowledges that reputational incentives may come into play inasmuch as controlling
shareholders may not wish to risk their reputation or that of the company but believes that these alone
do not constitute a reassuring solution to the problem in the absence of legal support.
14
See Reed (2004) generally, who suggests that the presence of Anglo-American models of corporate
governance could be due to historical ties, lack of success in previous interventionist models or debt or
influence of international financial institutions. Siddiqui (2010) suggests that Anglo American models
of governance were adopted in Bangladesh due to donor pressures.
Hari Bhardwaj
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addressed. While the Anglo-American approach is likely to be functional in an

environment where there is a separation of management and control by focusing on
the agency problem between managers and shareholders, measures in India that could
go into addressing the agency problem here would have to be quite different in order
to be functional.15
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
15
In fact, as we have seen, law and finance literature argues that concentration of ownership is in
itself a response to the first agency problem. We note, however, that there could also be significant
cultural issues that go into the question of efficacy of legislation. While we do not propose to go into
detail here, see the interview of a former SEBI Chairman for an overview of some of these cultural
issues (Damodaran, 2009). Varottil (2009) also argues that we need a model that resonates well with
Indian business values and practices.
Hari Bhardwaj
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The Need for Enforceability: Politics and Path

Dependence in India
We propose to explore in this chapter another issue that is central to the effectiveness
of legal measures implemented in India the question of enforcement. As we have
seen earlier, while some measures have been implemented to address corporate
governance in India, public enforcement of laws continues to be weak and protection
on paper often does not translate into actual protection (Chakrabarti, Megginson and
Yadav, 2008; Afsharipour, 2009). It is relevant to draw from Afsharipour (2009),
who poignantly identifies the following lessons based on a review of Indias
corporate governance experience (2009: 35):
It becomes clear that even with attentive crafting of detailed corporate
governance rules by a group of elites with a deep understanding of
corporate governance standards around the world, the reform process
is useless if an effective infrastructure for enforcement and
implementation is not in place. Thus, the corporate governance reform
process must account of these limitations in the crafting of new
standards..In fact, introducing formal rules into a system where
there is an inadequate infrastructure to support the implementation and
enforcement of such rules may mean that these rules have little chance
of succeeding.
We seek, in this chapter, therefore to understand why public enforcement does not,
and is unlikely to, at least in the short term, work well in India. We begin here by
setting the context for our analysis through a brief digression to introduce what is
commonly termed the political approach to corporate law.
The political approach to corporate law is generally premised on the fact that
corporate structures that exist in an economy depend on the structures with which the
economy began (Bebchuk and Roe, 1999). This approach argues, importantly, that
corporate rules that affect ownership structures in a country depend on the initial
ownership structures and that an important determinant of which rules will be chosen
Hari Bhardwaj
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is interest group politics (ibid: 157-8). Parties who participate in corporate control
under an existing structure have the incentive and power to impede efficient changes
that might reduce their private benefits of control. They acquire this power through
the resources they command which provide them visibility, media access, high social
status, and access to influential groups, and which they use to influence the corporate
rules system (ibid: 159-60).
This political view has acquired much traction in mainstream law and
finance literature. In an influential paper, Rajan and Zingales (2003) argue that
incumbent firms seeking to retain market power lobby for weak investor protection
that makes it difficult for other firms to raise capital. More recently, Bebchuk and
Neeman (2010) argue that insiders, institutional investors and entrepreneurs compete
for influences over politicians in setting the level of investor protection.
Not surprisingly, there is much support for this theory in India. Reed (2002:
266) argues that business families use their resources to influence policy in order to
retain control. Khanna and Palepu (2005) argue that rent seeking does not fully
explain the reasons for concentrated ownership in India and that politics plays a
significant role in its persistence. Armour and Lele (2009) find substantial support for
political theories to explain existing structures in India and find that powerful
networks and high concentration of wealth of leading business families helps them to
act as an effective interest group in seeking regulatory reform and that the needs of
businesses as opposed to investors and employees appear to be heard most loudly by
those responsible for reform. In short, they conclude that political economy
explanations have traction in explaining the case of India.
Hari Bhardwaj
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While the above arguments indicate that politics affects law, does it affect
enforcement as well? The answer is not as clear. Bebchuk and Roe however make the
point below (1999: 155):
Principles are important, but the devil is in the details, and
implementation counts a great deal. Two countries may be hostile to
self-dealing in principle, but their overall legal treatment of selfdealing might differ greatly because of differences in the procedures
that corporations must follow in approving a self-dealing transaction,
in the nature and timing of the disclosures that the firm or the
controller must make, in the incentives that public investors or
plaintiffs lawyers have to sue, in the procedures that such suits have
to follow, in the standards of scrutiny that courts use, in the level of
deference that courts give to the insiders judgments, in the extent to
which an effective discovery process is available, and in the ways in
which evidence will be brought and considered.
Therefore, we can see that there is much influence that politics and power
play could potentially have when it comes to enforcement of the law. The efficacy of
civil procedures relating to suit and evidence, the adequacy and expertise of courts,
the standards of scrutiny that they use, lawyers and plaintiffs incentives to sue and
legal costs all go into determining how easy or difficult it is to bring actions in courts.
The Indian judicial system suffers from weaknesses on all these fronts (Chakrabarti,
Megginson and Yadav, 2008; Afsharipour, 2009; Armour and Lele, 2009; World
Bank/ IFC, 2011). The political view thus suggests that it may well be in the interests
of the incumbents not to reform or invigorate what are commonly termed as
defendants courts in India.
Moving away from the political argument, we find that there are other reasons
why suggesting that we merely strengthen the existing enforcement infrastructure
may be seen as a simplistic solution to address the core problem (assuming that
laws address the right agency problem). Bebchuk and Roe (1999) also argue that
existing legal rules have an efficiency advantage since various players managers,
Hari Bhardwaj
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owners, lawyers, accountants - may have invested in human capital, and modes of
operation that fit existing corporate rules. Their path dependence argument, which
rests on economic efficiency, indicates that replacing these rules would require
players to make new investments whereas efficiency may require that existing rules
and ownership structures are reinforced rather than amended (ibid). They argue,
therefore, that in designing laws, whether and the extent to which existing
infrastructure warrants change has to be considered (ibid).
While, in efficiency terms, this may just come down to whether the extent of
switching costs exceed the benefits from the changes in the law, we need to
consider the potential costs involved in combating bureaucratic inertia, addressing
conflicts of interests, revamping existing structures, and retraining existing
professionals in a vast country such as India. Thus, although the path dependence
argument may not in itself pre-empt change, it appears likely that the time taken to
effect change will be significant and the costs involved will be high. For example, a
problem involving a severe shortage of trained judges would be difficult to rectify
even in the presence of political will, and impossible to do so in its absence.
Thus, we find that political economy concerns suggest that the ability to adopt
effective public laws and enforce existing corporate governance measures will remain
weak in India. In addition, the costs of addressing defects in existing structures are
likely to be prohibitive. We therefore consider, that in developing solutions, at least in
the short term, we need to consider structural constraints, and a focus on substantive
regulation to the exclusion of its enforceability is unlikely to be effective. With this
background, we focus our attention on devising self-enforcing solutions that utilise
not just actors economic incentives but also consider potential conflicts.
Hari Bhardwaj
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Towards Solutions
We are now in a position to enquire as to what measures may be suitable to address

the corporate governance problem that we have identified earlier in this paper. More
specifically, we ask, given the form of the corporate enterprise in India, the issues
with transplanting Anglo American corporate governance measures and the weak
enforcement environment in India (which is likely to continue given the background
political environment), can we suggest solutions to reduce the expropriation of
minority shareholders by controlling shareholders in India?
We begin our search with a general overview of likely enforcement
frameworks within which we can consider placing potential solutions.
5.1
Enforcement Mechanisms: A Typology
Berglof and Claessens (2006) develop a broad framework to help explain

enforcement and provide a typology of different forms of enforcement mechanisms
that we find useful for our analysis. They classify enforcement mechanisms into three
categories (Berglof and Claessens, 2006: 125): first, private ordering initiatives,
which they define as transactions that take place in the absence of laws and courts or
other public enforcement institutions; second, private enforcement of the law
which occurs when private agents avail themselves of the framework defined by law
or regulations to punish violations from contracts, using the courts to adjudicate and
the state to enforce the final judgment and; third, public enforcement which
involves the enforcement and prosecution of the law by the government.16
We see, from the above classification, that enforcement mechanisms rely on
the efficacy of certain institutions the state and the market although to varying
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
16
While there is significant literature that expands on each of these categories we found that the
Berglof and Claessens classification was the most succinct and, therefore, propose to rely on this
framework.
Hari Bhardwaj
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degrees. While private ordering mechanisms are often dependent on the efficacy of
markets, public enforcement mechanisms are almost entirely dependent on state
institutions for their efficacy, and private enforcement mechanisms fall somewhere in
between. Where either of these institutions are absent, or are limited in their
effectiveness (for example, where they are unable to effectively impose sanctions),
the effectiveness of the related enforcement mechanism will correspondingly suffer
(ibid). We can therefore see that the extent of reliance that we can place on each
enforcement mechanism in a country will depend on the strengths of its institutions.
We therefore continue our enquiry by exploring the efficacy of these in the Indian
context.
5.2
Enforcement Mechanisms and Institutional Maturity: Courts and
Markets
We begin by exploring the efficacy of that institution of the state that goes
into determining the efficacy of public enforcement mechanisms the judicial
system. As we have indicated earlier, the picture here is fairly dismal in India. It not
unusual for preliminary hearings to take years and for final decisions to take decades
(Afsharipour, 2009; Armour and Lele, 2009), and measures addressed to resolve
these issues such the introduction of tribunals have only seen limited success. India is
known to suffer from a severe shortage of trained judges, and there are multitudes of
cases pending before its Supreme Court, High Courts and its local courts (Armour
and Lele, 2009). The reality is that the Indian judicial system, at best, is characterized
by delays and, at worst, is dysfunctional and corrupt.
The second institution that we consider in our analysis are markets more
specifically, the equity markets, since our paper is concerned primarily with public
listed companies. In stark contrast, we have seen that over the past two decades,
Hari Bhardwaj
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equity markets in India have grown at a tremendous pace. Stock markets in India
have grown to be active, fairly developed and are seen to be progressive (Panagariya,
2008). The ratio of market capitalization to GDP, a commonly adopted measure in the
literature to measure the reliance on equity finance relative to size of the economy as
a whole (that is, the depth of equity markets), indicates that markets in India are
deeper than comparable developing countries and, indeed, some developed countries
(Armour and Lele, 2009).
In short, therefore, it seems more useful for us to place our trust in exploring
private ordering or private enforcement of law mechanisms that rely on the markets
efficacy, than in public enforcement measures that are dependent on the efficacy of
its judicial systems. Having concluded that it is wise to consider the use of economic
or legal strategies that rely on the efficacy of market based, rather than state based,
enforcement mechanisms, the question that arises is what strategy we can adopt to
leverage its strengths. We proceed to delve into this question next.
5.3
Honing in on Strategies
Having considered an approach that is focused on self enforcement, our concern is

to consider whether we can discover legal or economic strategies that elicit voluntary
compliance. In an extreme form of private ordering, obviously, we anticipate little or
no role for the law, or, indeed, legal strategies. However, since we are not restricting
our focus to this extreme scenario, it is useful to explore whether there are strategies
that are consistent with our preferred approach. To address this question, we consider
it useful to revisit the agency framework within which we had placed our core
corporate governance problem.
Kraakman et al. (2009) usefully describe a basic set of legal strategies, or
generic methods of deploying substantive law to mitigate the vulnerability of
Hari Bhardwaj
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principals to the opportunism of their agents (2009: 37). These include regulatory
strategies, which are largely prescriptive and dictate substantive terms that govern
the principal agent relationship, and governance strategies, that seek to facilitate
principals controls over their agents behaviour.17 According to them, while
regulatory strategies require strong institutions in order to work, governance
strategies depend on the ability of principals to exercise their control rights
(Kraakman et al., 2009: 38). For governance strategies to work, first, principals
should be able to observe the actions taken by agent, and second, they should be able
to exercise their control rights by either monitoring the agent, or by deciding
whether and how to take action to sanction non performance (ibid). The former action
is typically carried out through the grant of appointment rights, and the latter
through decision rights.
Usefully for us, Kraakman et al. (2009) proceed to identify a third form of
governance strategies, one of which assumes particular importance when we consider
self enforcing models of corporate governance. They identify incentive strategies,
that alter the incentives of agents rather than expand the powers of principals (ibid:
42). They give two examples of these reward strategies, which focus on rewarding
agents for advancing the interests of their principals, and trusteeship strategies,
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
17
The strategies they discuss are summarized below.

Table 1: Regulatory Strategies and Governance Strategies
Regulatory Strategies
Governance Strategies
Agent Constraints
Affiliation Terms
Appointment
Rights
Decision
Rights
Agent
Incentives
Ex Ante
Rules (require or
prohibit specific
behaviors)
Entry
Selection
Initiation
Trusteeship
Ex Post
Standards (leave
precise determination
of compliance to
adjudicators)
Exit
Removal
Veto
Reward
Source: Kraakman et al., 2009: 39

Hari Bhardwaj
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which seek to remove conflicts of interest ex ante to ensure that an agent will not
obtain personal gain from disserving her principal (ibid: 43).
We can see that, not only are some of these strategies consistent with an
approach relying on market-based enforcement mechanisms, but that some of the
factors that are seen to influence their effectiveness lend themselves to useful
analysis. For example, since governance strategies depend on principals actions,
having a multitude of principals could lead to potentially high coordination costs and
impair governance. Similarly, where principals interests or incentives are not
aligned, conflicts of interests can impair effective governance. Having set out this
framework, we feel able to move to the next stage of our paper - one that focuses on
identifying solutions for the core corporate governance problem in India.
5.4
Developing Solutions
We propose to begin by identifying potential actors who could play a role in

addressing the core problem of corporate governance that we had restated at the
beginning of this chapter. Second, we propose to focus our efforts on evolving criteria
to determine the utility of actors in addressing the core problem. Third, we propose to
evaluate each our identified actors utility against these criteria. Finally, we propose
tentative solutions to the problem in light of this analysis. 18 !
5.4.1
Identifying key actors: non-controlling shareholders
We begin our discussion here by first identifying which actors could play a role in
addressing the agency problems between non-controlling shareholders, as principals,
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
18
A caveat is in order here. We could also consider classifying companies in India based on their
different types of ownership since the manner and extent of agent problems that could arise in will
vary in each of these forms. For instance, tunneling may be higher in group/ family owned companies
in India (who are likely to divert funds to other group companies to the exclusion of minority
shareholders), or foreign owned companies (who might seek to divert funds to their outside investors).
This could imply that more than one model may be required. However, we restrict our focus to a
generic model here for the sake of brevity.
Hari Bhardwaj
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and controlling shareholders, as agents. Since we had intended to focus on

governance strategies, our proposal is to consider potential actors who could perform
a monitoring role. Further, since our focus is on self-enforcement, it is useful to
identify actors who have an incentive in themselves, or who can be incentivized, to
perform this role.
We draw up our preliminary list of actors from those who are participants in
Indian public listed companies. The first obvious choice for a monitoring role is the
non-controlling shareholders themselves. A second choice is independent directors,
and a third is auditors.
Of the above, we propose to leave out independent directors as actors because,
as we have seen earlier, unless they are appointed by someone other than the
controlling shareholders, they would not have the ability or incentives to address the
agency problem that concerns us. We find that auditors are also subject to the same
concerns. While we might argue that we consider having them appointed by a third
party, say the state; however, this would create a separate set of agency problems and
conflicts of interest, besides being inconsistent with our aim of finding solutions
within the existing framework.
We therefore choose to maintain our focus on the use of non-controlling
shareholders in our analysis.19 !
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
19
! We are supported in our choice by evidence in literature, although not directly, that indicates that
certain categories of non-controlling shareholders can help address corporate governance problems.
For instance, in a dispersed shareholding setting, it has been argued that investors with large ownership
stakes have strong incentives to maximize their firms value and are able to collect information and
oversee managers and thereby override conflict of interests between shareholders and managers (and
address the agency problem) (Claessens et al., 2002).
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5.4.2
Who among non-controlling shareholders?
Continuing with our analysis, we find it useful to classify non-controlling

shareholders into different categories rather than consider them as a single monolithic
unit. To this end, we classify non-controlling shareholders into foreign institutional
investors, domestic institutional investors, and retail investors. We further sub
categorise retail investors into domestic retail investors, holders of American or
Global Depositary Receipts (ADR/ GDR holders) and employee retail investors. 20
5.4.3
Criteria to define the utility of potential actors
!
We consider the following factors to be relevant in determining the utility of each of
our identified categories of non-controlling shareholders (or each potential actor) in
monitoring controlling shareholders: first, the extent of information that is likely to be
available to the potential actor in order to discharge her role effectively; second, the
potential for conflict of interest in the potential actor discharging her duties as a
monitor, i.e., is the interest of the potential actor also to maximize shareholder value,
or do other interests comes into play (to an extent this also helps address the political
dimension of our analysis, although it is not specifically designed to do so); third, the
degree of potential co-ordination costs in having the potential actor discharge a
monitoring function (which could include, the difficulty in or costs associated with
acting collectively or the ease with which others could free ride on her efforts); and
fourth, the likelihood that the potential actor would continue to be associated with the
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
20
In making this classification, we largely draw inspiration from filings Indian public listed companies
are required to make under Clause 35 of their listing agreement with the stock exchanges on which
they are listed. Pursuant to SEBI regulations, public listed companies in India are required to disclose
on a quarterly basis the pattern of their shareholding in a format prescribed by the stock exchange
under Clause 35 (BSE, 2010). We have considered retail investors to include domestic retail investors,
ADR/ GDR holders and a third category of employee retail shareholders. While Clause 35 does not
require employee shareholders to be separately classified, given the increased popularity of shares/
stock options amongst Indian companies to reward their employees, we identify them as a separate
sub-category of non-controlling retail investors.
Hari Bhardwaj
June 2011
38!
firm rather than exit it (which is of particular significance, since the primary way in
which a non-controlling shareholder would respond to the threat of expropriation by
the majority shareholder is by exiting the firm, thus devaluing her utility as an actor).
5.4.4
Assessing the utility of each group of non-controlling shareholders
We now attempt to assess the utility of each potential actor based on the above
criteria. We caution here that in the absence of clear empirical data, our analysis only
serves as a best guess of their utility, and rather than being seen as conclusive, it
ought to be seen as a guide to understanding how the utility of each category of noncontrolling shareholders may vary when we consider incentivizing them.
(a)
Foreign Institutional Investors
We begin with this category of investors since the empirical evidence in support of
their monitoring role seems the best known. For instance, Sarkar and Sarkar (2000)
find that ownership by foreign institutional investors is positive for firm value beyond
a certain threshold of ownership. Khanna and Palepu (2000) find that foreign
institutional investment is associated with significant monitoring benefits and firm
performance is positively correlated with presence of foreign institutional ownership.
Applying the criteria we have developed above, however, we find the
following: first, that this group have access to the same amount of information as
other potential actors and can be seen to have no special advantages in this regard;
second, that they clearly have an interest in maximizing shareholder value (and, also,
given that they are fairly sophisticated, it is likely that controls would be in place to
address potential internal agency problems that may affect this interest); third, that
they are likely to face significant coordination costs since they are not domiciled in
India, that they do not form a homogenous set of investors and are likely to face
increased collective action problems; and fourth, that they are unlikely to continue to
Hari Bhardwaj
June 2011
39!
be invested in firms, and likely to be sensitive to poor returns, by exiting quickly, and
indeed, often do so. They are also most susceptible to adverse selection problems
inasmuch as the information asymmetries are likely to be the highest in this category
of investors.
(b)
Domestic Institutional Investors
Domestic institutional investors, unlike foreign institutional investors, have often

been criticized for much of the ills that plague corporate governance in India today
(Goswami, 2002; Chakrabarti, 2005). The empirical evidence regarding their
monitoring role is more mixed. While Khanna and Palepu (2000) find that firm value
is negatively correlated with domestic institutional ownership, Sarkar and Sarkar
(2000) find conflicting evidence with domestic institutional investors having no
positive impact on firm value and development financial institutions increasing
company value beyond a certain level of equity holding and suggest that they may be
effective monitors provided there are counteracting factors to neutralize the agency
problems associated with government ownership.
Our analysis as regards their utility as monitors is set out below.
First, as with foreign institutional investors, many of them are likely have
access to the same amount of information as other investors and can be seen to have
no special advantages in this regard. However, large domestic institutional investors,
or those who are repeat players in the Indian stock markets, for instance, certain
banks may have informational advantages over other categories of investors.
Second, while many of them may have an interest in maximizing shareholder
value, but where the state has a controlling stake in them, they may become subject to
conflicts of interest in the form of having political agendas thrust on them (ibid).
Also, where they are state owned or controlled, they may face agency problems of
Hari Bhardwaj
June 2011
40!
their own: since there would be a separation of control and cash flows where the
bureaucrats who make investment decisions may not be rewarded based on the
quality of their investments, they may therefore have little incentives to chase returns
(Chakrabarti, 2005).
Third, they are likely to face a lower degree of coordination costs than foreign
institutional investors since, in general, their holdings are likely to be larger, and that
the same institutions may hold shares of many companies.
Finally, they are likely to be less mobile than foreign institutional investors
since they are less likely to withdraw funds from Indian companies and invest them
abroad. Also, they are likely to be less dynamic in moving investments due to the
nature of their returns. They might also be subject to tax considerations, such as
preferential treatment for longer holdings.
(c)
Retail Investors
Finally, we analyse below the utility of retail investors as potential monitors and, as
we indicated earlier, distinguish between domestic retail investors, employee
investors, and foreign retail investors as the context requires.
Retail investors are, in general, likely to be the least informed category of
investors, when we consider information required to discharge a monitoring role with
foreign investors likely to be less informed than domestic retail investors. Employee
investors, on the other hand, being insiders are likely to be better informed.
Retail investors are likely to have a general interest in maximizing shareholder
value. Employee investors (especially where they have unvested stock options or
remuneration tied to firm value) are likely to have a strong interest in maximizing
firm value but at the same time likely to be subject to conflicts of interests in certain
situations as, for instance, where a firm considers remuneration structures.
Hari Bhardwaj
June 2011
41!
Retail investors are likely to face the highest degree of coordination costs with
foreign investors being subject to even higher coordination costs than domestic retail
investors. Employee investors are however likely to be subject to a lower level of
coordination costs due to their proximity.
Retail investors are likely to fall somewhere between foreign and domestic
institutional investors when it relates to their continuity. They are unlikely to continue
to be invested in firms, and likely to be sensitive to poor returns, by exiting quickly.
Employee investors on the other hand are less likely to exit, particularly as they are
subject to non diversifiable investments.
5.4.5
Identifying solutions
Thus, based on our analysis, which we summarise in the table below, we find that
domestic institutional investors have greater utility than foreign institutional investors
as monitors. While retail investors, in general, have less utility as potential monitors
than domestic institutional investors, a sub-category of these investors, employee
retail investors, have greater utility as potential monitors.
Table 2: Utility of categories of Non-Controlling Shareholders as monitors
1
2
3
(a)
(b)
(c)
Category
of Extent
of Potential
Extent
of
Potential Actor
Information for
CoAvailable
Conflict of ordination
Interest
Costs
Foreign
Low
to Low
High
Institutional
Moderate
Investors
Domestic
Moderate to Moderate to Low
to
Institutional
High
High
Moderate
Investors
Retail Investors
Domestic Investors Low
Low
High
ADR/
GDR Low
Low
High
holders
Employee
High
High
Low
Investors
Source: Based on independent analysis.
Hari Bhardwaj
Potential
for
Continuity
Low
Moderate to
High
Moderate
Low
High
June 2011
42!
We therefore conclude that governance measures that seek to address

corporate governance in India ought to focus on domestic institutional investors or
employee retail investors, who we classify, for ease of reference as key potential
actors.
Reverting to the broader corporate governance question under consideration,
we can see that it is in both the interest of the category of non-controlling
shareholders taken as a whole (as principals), and in the self interest of these key
potential actors to exploit the utilities that we discuss above. In light of the
enforcement frameworks and legal strategies that we had earlier identified, we
contemplate that our analysis thus allows for two separate sets of measures: the first,
in the form of governance measures designed or implemented by the category of noncontrolling shareholders as a whole that exploit the utilities of the key potential actors
and rely on a private enforcement mechanism in order to be effective; and the second,
in the form of self-governing measures that may be implemented by the key actors
themselves and can therefore be self enforcing.
In designing governance measures, the former set of measures can also deploy
a trusteeship or reward strategy where other sets of non-controlling investors can
assign a role, or offer a reward to the key potential actors in order to incentivise them
to discharge their monitoring role. For example, we could think of a solution that has
non-controlling shareholders, or a certain category of them, using employee
shareholders as monitors. This could involve the former funding or institutionalizing
a bounty whistleblower mechanism which is based on employee retail investors
blowing the whistle when they come across instances of minority shareholder
Hari Bhardwaj
June 2011
43!
expropriation.21 The informational advantages that employee retail investors possess

would enable them to be effective monitors, even as the possibility of a bounty
could act to incentivise them to act as such. However, as we have seen, these key
potential actors are also likely to be subject to conflicts of interest where their
interests may vary from those of the other principals. To explain how conflicts of
interest could play out in such a situation, should the expropriation that we discuss
above result in private benefits accruing to the employee shareholder, it is likely that
her utility as a monitor would be undermined to some extent. Thus, a bounty
whistleblower mechanism would also have to incorporate safeguards to address
potential conflicts of interest.
A self enforcing corporate governance mechanism that involves the second
key potential actor that we identify domestic institutional investors is also
possible, although a different set of concerns is likely to come into play here. For
instance, domestic institutional investors in India may choose to utilize the strength of
market institutions by developing and institutionalizing a joint rating mechanism
(not unlike that deployed by activist funds such as CalPERS) which would determine
which firms these institutions would invest in, or retain their investments in, and
which firms they would not. Where they believe that a firms owner manager is
engaging in expropriation, they could lower the rating that they assign to the portfolio
firm, which would lead to withdrawals of their investments. Furthermore, a lowering
in the rating or even a threat to do so would send strong signals in the market to other
categories of non-controlling investors and thereby ex ante prevent minority
shareholder expropriation. Finally, in order to overcome their informational
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
21
While outside the scope of the law and finance domain, softer mechanisms such as educating
employees about who the actual owners of a company are may also have a role to play; if one is able to
establish in employee shareholders a sense of ownership, they may be more incentivized to play a
monitoring role than otherwise.
Hari Bhardwaj
June 2011
44!
shortcomings, a potential concern that we identify in our analysis, domestic

institutional investors could evolve mechanisms whereby they share information
amongst themselves to assist in monitoring their portfolio of companies in which they
hold investments.
Hari Bhardwaj
June 2011
45!
Conclusion
It isn't that they can't see the solution. It's that they can't see the problem.
G. K. Chesterton (1935)
The main aim of this paper was to establish whether, despite the constraints
surrounding India today, there were ways by which we could progress towards the
development of effective corporate governance solutions. As we pointed out early in
our discussions, a related motivation that underlay our attempt was that while much
research has gone into the problems affecting corporate governance in India, not
enough has gone into identifying potential solutions.
We believe that that the single most important contribution of this paper is to
show that even when we consider the various potential hindrances - of enforcement,
of concerns of political economy, of limitations in institutional frameworks - there are
potentially feasible solutions available to address the core corporate governance
problem in India today. !
There is merit in summarizing the process we adopted in arriving at potential
solutions. First, a review of the nature of firm ownership in India revealed that public
listed companies are largely subject to concentrated ownership. Thus, the core
problem of corporate governance in India, when understood in economic terms, was
not the threat that managers act opportunistically against the owners as is prevalent in
the Anglo-American world, but that majority shareholders could act opportunistically
against minority shareholders. Second, we recognised that the transplant effect,
which considers that solutions adopted from Anglo-American countries are unlikely
to be effective since they address the wrong agency problem, needs to inform an
approach that seeks to identify corporate governance solutions for India. Third, we
identified limitations in the institutions of public enforcement in India and drew upon
Hari Bhardwaj
June 2011
46!
the political approach to corporate law to conclude that these structural constraints
affecting Indian corporate governance are likely to limit the effectiveness of purely
legalistic solutions in India, at least in the short to medium term. Fourth,
recognizing the rapid development in Indian stock markets, we sought to identify
corporate governance solutions that leverage the strengths of its market, rather than
depend on its courts. Fifth, we identified minority shareholders themselves as
potential actors of utility in addressing the core corporate governance problem, sub
categorized them into different actor groups and used criteria developed by us to
evaluate the utility of each of our identified categories as monitors. We finally
identified domestic institutional shareholders and employee shareholders as having
greater utility as monitors than other categories of minority shareholders, and
concluded our analysis by drawing out potential self enforcing market based
solutions.
We are cognizant that a role for minority shareholders to take up a more
active role in corporate governance could well lead to other concerns. We might
heavily underestimate potential conflicts of interest for one. Minority shareholders
may themselves be subject to agency problems or seek to derive private benefits from
their business relationships to the neglect of their monitoring role. We realize that a
market driven approach could thus result in new sets of problems, and emphasise that
there remains a need for vigilance in identifying and addressing these problems.
At the same time, our objective is not to suggest that more legalistic tools,
such as the introduction of voting constraints or rights favouring minority
shareholders are not likely to be effective in improving corporate governance in India.
Rather, we suggest that despite the pace at which India markets have developed,
market based solutions have been underexplored. More generally, for its long-term
Hari Bhardwaj
June 2011
47!
success, the emphasis continues to be on a need for India to develop and strengthen
its institutions as without a strong enforcement environment, private ordering may be
the only viable option.
We conclude with the hope that this paper acts to stimulate an agenda for
future research. We can think of two areas that would help facilitate progress first,
research that seeks to evaluate the strength of private enforcement over public
enforcement, whether in India or in other similarly placed emerging economies.
Second, research that seeks to build customized self- enforcing solutions to
emerging or transition economy corporate governance problems but that which
adopts a holistic approach such as the one attempted by this paper. Indeed, the
complexity surrounding not just India, but most emerging economies suggests that it
is only such an approach that is likely to be effective. As Einstein (n.d.) reminds us:
The problems we have today, cannot be solved by thinking the way we thought when
we created them.
Hari Bhardwaj
June 2011
48!
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CORPORATE GOVERNANCE IN INDIA:

Corporate Governance in India: Towards a More Holistic Approach!

The Need for Enforceability: Politics and Path Dependence in India........ 27

5 Towards Solutions .............................................................................................. 31

Corporate Governance in India: Towards a More Holistic Approach!

Corporate Governance in India: Towards a More Holistic Approach!

While developing corporate governance measures for India, inspiration has

Corporate Governance in India: Towards a More Holistic Approach!

to corporate governance in India. In the final chapter, we consider, in light of our

Corporate Governance in India: Towards a More Holistic Approach!

Corporate Law and Corporate Governance

The Goals of Corporate Law

While there is undoubtedly no shortage of literature around this question, we find it

Corporate Governance in India: Towards a More Holistic Approach!

Corporate Governance in India: Towards a More Holistic Approach!

Corporate Governance in India: Towards a More Holistic Approach!

(Kraakman et al., 2009). Corporate governance can therefore be conceptualised in

Corporate Governance in India: Towards a More Holistic Approach!

Setting the Indian Context

A Brief History of the Corporate Enterprise in India

To set the context, it is worthwhile to briefly explore the beginnings and

Corporate Governance in India: Towards a More Holistic Approach!

During the period following independence, a number of legislative and policy

Corporate Governance in India: Towards a More Holistic Approach!

main providers of long term credit to companies (Chakrabarti, 2005). Although, in

Corporate Governance in India: Towards a More Holistic Approach!

Ownership and Control in India

Who owns public listed companies in India?

Source: Chakrabarti, Megginson and Yadav, 2008: 60

Corporate Governance in India: Towards a More Holistic Approach!

Corporate Governance in India: Towards a More Holistic Approach!

Figure 2: Promoter and Non Promoter holdings in Indian listed

Central and State

Source: Chakrabarti, Megginson and Yadav (2008)

Corporate Governance in India: Towards a More Holistic Approach!

as of March 31, 2010, the shareholding of 1,470 companies listed on it was

Any Other Institutional

Source: Adapted from NSE (2010)

Corporate Governance in India: Towards a More Holistic Approach!

50% and above

Source: Adapted from Rao and Guha (2006)

Corporate Governance in India: Towards a More Holistic Approach!

appear to continue to wield significant influence while institutional investors (both

Pinning down the Core Corporate Governance Problem in India

We begin here by revisiting our discussion on corporate governance from the

Corporate Governance in India: Towards a More Holistic Approach!

Corporate Governance in India: Towards a More Holistic Approach!

Reverting to the Indian context, even where controlling shareholders or

Corporate Governance in India: Towards a More Holistic Approach!

different problem may be ineffective in the Indian context. Before we proceed to

From Intuition to Reality: The Manifestation of the Problem in

Corporate Governance in India: Towards a More Holistic Approach!

There is also extensive anecdotal evidence to substantiate expropriation by

Corporate Governance in India: Towards a More Holistic Approach!

The Need for Customisation: the Transplant Effect

The Effectiveness of Laws in India

Corporate Governance in India: Towards a More Holistic Approach!

Corporate Governance in India: Towards a More Holistic Approach!

To summarise, while there is evidence that the introduction of Clause 49 has

The Transplant Effect

Corporate Governance in India: Towards a More Holistic Approach!