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Published: Fri, 02 Feb 2018
Ethics in dealing with Minority Shareholders
The evolution of business ethics in the last few years has been accomplished in parallel to the political, social and economical world developments. Business ethics has started to become an inevitable norm in most of the nations of the world.
In the increasingly conscience-focused marketplaces of the 21st century, the demand for more ethical business processes and actions (known as ethicism) is increasing. Simultaneously, pressure is applied on industry to improve business ethics through new public initiatives and laws (e.g. higher UK road tax for higher-emission vehicles). Businesses can often attain short-term gains by acting in an unethical fashion; however, such behaviors tend to undermine the economy over time.
A mutual shareholder or stockholder is an individual or company (including a corporation) that legally owns one or more shares of stock in a joint stock company. A company’s shareholders collectively own that company. Thus, the typical goal of such companies is to enhance shareholder value.
Since the reform process began in 1991, India Inc. has come a long way in terms of growth, cost reduction and productivity, resulting in healthy balance-sheets and good returns on capital employed. Indian economic policy made a radical shift by dismantling the entire edifice of micro management and controls. Industrial Licensing was abolished and foreign investment allowed in most sectors. Restrictions on large business houses were abolished and the MRTP Act radically changed. Restrictions on foreign trade were lowered to meet the new WTO norms. Simultaneously, the banking and capital markets were deregulated. The Indian firms were allowed to tap international capital markets and many listed themselves on the western stock exchanges. Foreign institutional investors were allowed to enter the Indian capital markets which substantially increased its size and depth. With the abolition of the restrictions on mergers and takeovers (including hostile takeovers) changed the entire landscape of Indian business. The Indian business conglomerates had so far been shaped by the industrial licensing policy and their success in lobbying for these licenses. Often the capacity in the same industry (eg. cement) was fragmented between numerous firms controlled by the same business house. Many units lacked global economies of scale as well as technology. The deregulation substantially increased the competitive pressures on Indian business, especially with the entry of multinational companies in areas earlier exclusively reserved for local firms and public sector. Access to bank credit and development finance became difficult and costlier. Credit rating became a pre condition. All this called for radical re structuring of the business portfolio in the Indian business houses. The first decade was spent in evaluating the business portfolios, selecting which to divest while improving the scale and competitive positions of others. Entry of multinational competitions now required Indian firms to have world class technology, product features and services along with global economies of scale. They were also required to erect strategic entry barriers and enhance their brands and distribution networks. This led to large scale mergers between groups companies (controlled by the same business house) to achieve scale and synergy. In addition there were acquisitions from outside the group to enhance product scope, brands or geographical reach.
The financial sector reforms and the changing nature of banking and capital markets generated pressures that had a direct bearing on corporate governance and policies. Credit ratings and access to markets required more transparent disclosures and financial scale to tap the new segments opening up. The capital markets also generated pressures to reduce intra groups investment as financial analysts and FIIs disapproved of such cross investments and diversion of funds. This was accompanied an aggressive entry by foreign firms into the Indian market. The foreign firms, almost without exception ejected their joint venture partners to more closely integrate their Indian affiliates in their global operations. Those foreign firms entering India for the first time became aggressive buyers of local firms with entrenched positions, distribution networks and capacity to speed their entry into India. The sharp devaluation of the rupee also made Indian corporate assets relatively cheap. This changing competitive scenario required a strategic response from the Indian business houses. They needed to consolidate their control in light of new rules permitting hostile takeovers. Divestiture of weaker or poorly performing units was necessary to protect many firms from hostile takeovers. The advantage to foreign firms with integrated global operations needed to be neutralized and the most successful houses embarked on a strategy of takeover and expansion in other countries.
We definitely have come a long way. The stock market is now helping fuel the growth of Indian corporates. This is amply reflected in the market capitalization of about $1 trillion, which is around the country’s GDP figure. But the challenge today is to be better than the rest of the world.
Listed companies need to appreciate the fact that they are not only accountable to minority shareholders but must also respect them as providers of risk capital. At present, the concerns of minority shareholders are hardly respected. There are a couple of serious issues of minority shareholder rights which have not caught the attention of either the regulators or the independent directors of listed companies. Most companies pay little thought to shareholder equality.
A much talked about regulatory dilemma is that of balancing the rights of minority shareholders against the principle of shareholder democracy. On closer examination, this regulatory dilemma is not as serious as it might appear at first sight. In many ways, the very term shareholder democracy represents a misguided analogy between political governance and corporate governance. Unlike political governance, corporate governance is primarily contractual in nature, and corporate governance is at bottom a matter of enforcing the spirit of this contractual relationship.
It is important to bear in mind that the relation between the company and its shareholders and the relation between the shareholders inter-se is primarily contractual in nature. The memorandum and articles of association of the company constitute the core of this contract and the corporate law provides the framework within which the contracts operate. The essence of this contractual relationship is that each shareholder is entitled to a share in the profits and assets of the company in proportion to his shareholding. Flowing from this is the fact that the Board and the management of the company have a fiduciary responsibility towards each and every shareholder and not just towards the majority or dominant shareholder.
Shareholder democracy is not the essence of the corporate form of business at all. Shares are first and foremost ownership rights – rights to profits and assets. In some cases (non voting shares for example) that is all there is to it. In other cases, shares also carry some secondary rights including the control rights – rights to appoint the Board and approve certain major decisions. The term shareholder democracy focuses on the secondary and less important part of shareholder rights. Corporate governance ought to be concerned more about ownership rights. If a shareholder’s ownership rights have been trampled upon, it is no answer to say that his control rights have been fully respected.
Equitable treatment of Minority Shareholders:
Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled. Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed. The principal stakeholders are the shareholders, management, and the board of directors. Other stakeholders include employees, customers, creditors, suppliers, regulators, and the community at large.
The corporate governance framework should ensure the equitable treatment of all shareholders, including minority shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.
Key elements of good corporate governance principles include honesty, trust and integrity, openness, performance orientation, responsibility and accountability, mutual respect, and commitment to the organization.
Of importance is how directors and management develop a model of governance that aligns the values of the corporate participants and then evaluate this model periodically for its effectiveness. In particular, senior executives should conduct themselves honestly and ethically, especially concerning actual or apparent conflicts of interest, and disclosure in financial reports.
Commonly accepted principles of corporate governance include:
Rights and equitable treatment of shareholders: Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by effectively communicating information that is understandable and accessible and encouraging shareholders to participate in general meetings.
Interests of other stakeholders: Organizations should recognize that they have legal and other obligations to all legitimate stakeholders.
Role and responsibilities of the board: The board needs a range of skills and understanding to be able to deal with various business issues and have the ability to review and challenge management performance. It needs to be of sufficient size and have an appropriate level of commitment to fulfill its responsibilities and duties. There are issues about the appropriate mix of executive and non-executive directors.
Integrity and ethical behaviour: Ethical and responsible decision making is not only important for public relations, but it is also a necessary element in risk management and avoiding lawsuits. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making. It is important to understand, though, that reliance by a company on the integrity and ethics of individuals is bound to eventual failure. Because of this, many organizations establish Compliance and Ethics Programs to minimize the risk that the firm steps outside of ethical and legal boundaries.
Disclosure and transparency: Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide shareholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company’s financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information.
Issues involving corporate governance principles include:
internal controls and internal auditors
the independence of the entity’s external auditors and the quality of their audits
oversight and management of risk
oversight of the preparation of the entity’s financial statements
review of the compensation arrangements for the chief executive officer and other senior executives
the resources made available to directors in carrying out their duties
the way in which individuals are nominated for positions on the board
Nevertheless “corporate governance,” despite some feeble attempts from various quarters, remains an ambiguous and often misunderstood phrase. For quite some time it was confined only to corporate management. That is not so. It is something much broader, for it must include a fair, efficient and transparent administration and strive to meet certain well defined, written objectives. Corporate governance must go well beyond law. The quantity, quality and frequency of financial and managerial disclosure, the degree and extent to which the board of Director (BOD) exercise their trustee responsibilities (largely an ethical commitment), and the commitment to run a transparent organization- these should be constantly evolving due to interplay of many factors and the roles played by the more progressive/responsible elements within the corporate sector. John G. Smale, a former member of the General Motors board of directors, wrote: “The Board is responsible for the successful perpetuation of the corporation. That responsibility cannot be relegated to management.” However it should be noted that a corporation should cease to exist if that is in the best interests of its stakeholders. Perpetuation for its own sake may be counterproductive.
The first and foremost is preferential issuance of equity warrants to the promoters. Equity warrant is an instrument allowing the subscriber the option to buy shares in a company at a pre-specified price at or before some future date. Thus, a warrant gives a right to the subscriber to buy a share but no obligation, hence it is different from partly paid-up shares.
In the last five years, a number of listed companies have issued equity warrants to promoters. These are basically done to shore up the promoters’ holding. It is a double whammy for minority shareholders: (a) they are denied participation at the same level as the promoter shareholders; and (b) the promoters, while subscribing to the warrants, essentially get an option from the company to pay only 10 per cent of the equity warrant’s value and an additional 18 months to pay up the balance. It is a major breach of trust and faith on minority shareholders.
Moreover, the Companies Act has no definition of warrant. In fact, the Act does not envisage issue of shares without an increase in the share capital, but the practice followed in the case of equity warrants is to credit this amount to the share application account.
Leaving aside the accounting treatment, it is disturbing that companies are issuing equity warrants without having any legal backing of either the Companies Act or the Securities Contracts (Regulation) Act.
In most cases, equity warrants were fully paid only if the market price of a particular company’s share were higher than the equity warrant’s price. Since the period available to subscribe is fairly long (18 months), it gives promoters a huge opportunity to ride the stock market. Thus, there is a clear evidence of promoters profiteering by issuance of such equity warrants.
There is also another issue of conflict. As per the Takeover Regulation, promoters can increase their shareholding by buying the company’s shares to the extent of only up to 5 per cent of the equity capital during one financial year. And, now, with promoters being issued equity warrants (in most cases more than 5 per cent), they corner more shares by bypassing the Takeover Regulation and that too by paying just 10 per cent upfront. A rights issue of shares, allowing all shareholders to participate, would not have allowed them to disproportionately increase their holding in the company.
Equity warrants do not bode well for the development of good corporate governance practices and growth of the capital markets. It is hoped that the Securities and Exchange Board of India (SEBI) will stop the practice of issuance of equity warrants to promoters. There are enough ways and means to raise the equity capital required by a company and all shareholders should be allowed to participate equally. And if the capital required is large, then outside investors can participate through various other options.
Another area of concern is restructuring of listed companies. This requires immediate attention, more importantly for protection of the interests of minority shareholders. Barring some, most corporate restructuring, especially de-mergers, have been at the cost of the minority shareholders. Though, most of the restructuring schemes are legally compliant, they hardly protect the interests of minority shareholders and, to a large extent, corporate governance is disregarded.
It is ironical that while acquisitions are under the purview of SEBI, mergers and de-mergers continue to be a domain of the courts. Considering that courts are already overburdened, it is virtually impossible for them to pay full attention and appreciate the interests of minority shareholders; in practically all such cases the minority shareholders are not even represented.
Courts merely rely on the framework of the Companies Act and the compliance of listing agreement approved by stock exchanges. Seldom is any scheme amended to protect the interests of minority shareholders. With domestic companies aspiring to become global players and with heightened activity in the mergers and acquisitions space, it is time mergers and de-mergers schemes were made not only legally compliant but also protective of minority shareholders. All such schemes should be approved by the shareholders (by postal ballot) and SEBI rather than the courts. There are numerous cases where de-mergers have been done solely for the benefit of certain class of shareholders. Many-a-times de-mergers are done just to assuage family scuffles. The listed company is split into smaller entities and given to each of the sparring family members with disregard to corporate governance and minority shareholders.
It is time the promoters of listed companies stopped considering companies as their fiefdoms. Corporate restructuring should not merely be legally compliant but, more importantly, it should protect the interests of all the stakeholders. In this context, the role of the independent director on the board would be of paramount importance and they should be held responsible and accountable to the minority shareholders.
For our capital markets to be a global investment destination and before provident fund and pension fund monies are deployed into equity markets, it is important that the interests of minority shareholders are protected.
The Rise of the Minority
The past few years have witnessed a silent revolution in Indian corporate governance where managements have woken up to the power of minority shareholders who vote with their wallets. In response to this power, the more progressive companies are voluntarily accepting tougher accounting standards and more stringent disclosure norms than are mandated by law. They are also adopting more healthy governance practices. It is evident that these tendencies would be strengthened by a variety of forces that are acting today and would become stronger in years to come. The reasons due to which corporate governance has seen improvements are as follows:
1. Deregulation: Economic reforms have not only increased growth prospects, but they have also made markets more competitive. This means that in order to survive companies will need to invest continuously on a large scale.
2. Disintermediation: Meanwhile, financial sector reforms have made it imperative for firms to rely on capital markets to a greater degree for their needs of additional capital.
3. Institutionalization: Simultaneously, the increasing institutionalization of the capital markets has tremendously enhanced the disciplining power of the market.
4. Globalization: Globalization of our financial markets has exposed issuers, investors and intermediaries to the higher standards of disclosure and corporate governance that prevail in more developed capital markets.
5. Tax reforms: Tax reforms coupled with deregulation and competition have tilted the balance away from black money transactions. This makes the worst forms of misgovernance less attractive than in the past.
The corporate governance framework should ensure the equitable treatment of all shareholders, including minority shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.
The main challenges in ensuring equitable treatment of minority shareholders include:
1. Ensuring that the Board adopts a shareholders’ perspective when making decisions and ensuring minority shareholders’ interests are protected;
2. Improvements to the corporate governance;
3. Concerns of stakeholders at large vs shareholders of the Company;
4. Improving communications and interactions between minority shareholders, Board members and management;
All these concerns of minority shareholders will be met substantially if a corporate house is able to ensure that the basic rights of the minority are met. These basic rights with their constituents are mentioned below:
I. Equitable Treatment.
1. Same voting rights for shareholders within each class.
2. Ability to obtain information about voting rights attached to all classes before share acquisition.
3. Changes in voting rights subject to shareholder vote.
4. Vote by custodians or nominees in agreement with beneficial owner.
5. AGM processes and procedures to allow for equitable treatment.
6. Avoidance of undue difficulties and expenses in relation to voting.
II. The right to seek information
1. Right to know about the price sensitive information of the company,
2. Fairness to all shareholders irrespective of each individual’s shareholdings.
3. Right to inspect the Register of Members, Directors, Charges, Debenture Holders, etc and get copy thereof.
4. Right to receive Notice of General Meetings (the AGM or the EGM).
5. Rights to receive annual report and audited accounts.
6. Right to receive quarterly and annual accounts.
7. Right to inspect the Minutes of General Meetings.
8. Right to be kept fully informed of what is happening in the company.
III. The right to voice opinion
1. Right to attend general meetings.
2. Right to requisition for a general meeting.
3. Right to get the court to direct the company to call a general meeting.
4. Right to appoint proxies to attend and vote at a general meeting.
5. Right to be heard and make proposals at shareholders’ meeting.
6. Right to vote and elect directors and fix their remuneration.
7. Right to nominate director.
8. Right to appoint auditors and fix their remuneration.
9. Right to receive dividends, if declared.
IV. Disclosure and Transparency
1. Disclosure of material information
2. Financial and operating results
3. Company objectives
4. Major share ownership and voting rights
5. Board members, key executives and their remuneration
6. Material foreseeable risk factors
7. Material issues regarding employees and other stakeholders
8. Governance structures and policies
V. The right to seek redress
1. Common law derivative action
2. Redress mechanism under the Companies Act
3. Redress mechanism under the Securities Laws
The primary protection to minority shareholders is laid down in the companies law. Some of these provisions are the regulatory equivalent of an atom bomb – they are drastic remedies suitable only for the gravest cases of misgovernance.
I. Protection of minority shareholders
Company law provides that a company can be wound up if the Court is of the opinion that it is just and equitable to do so. This is, of course, the ultimate resort for a shareholder to enforce his ownership rights. Rather than let the value of his shareholding be frittered away by the enrichment of the dominant shareholder, he approaches the court to wind up the company and give him his share of the assets of the company. In most realistic situations, this is hardly a meaningful remedy as the break-up value of a company when it is wound up is far less than its value as a “going concern”. It is well known that winding up and other bankruptcy procedures usually lead only to the enrichment of the lawyers and other intermediaries involved.
Company law also provides for another remedy if the minority shareholders can show that the company’s affairs are being conducted in a manner prejudicial to the interests of the company or its shareholders to such an extent as to make it just and equitable to wind it up. Instead of approaching the Court, they can approach the Company Law Tribunal). The Company Law Tribunal which is a quasi-judicial body can make suitable orders if it is satisfied that it is just and equitable to wind up the company on these grounds, but that such winding up would unfairly prejudice the members. In particular, the Tribunal may regulate the conduct of the company’s affairs in future, order the buyout of the minority shareholders by the other shareholders or by the company itself, set aside or modify certain contracts entered into by the company, or appoint a receiver. The Tribunal could also provide for some directors of the company to be appointed by the Central Government, or by proportional representation. The Tribunal normally entertains such complaints only from a group of shareholders who are at least one hundred in number or constitute 10% of the shareholders by number or by value.
II. Special majority
Another safeguard in the company law is the requirement that certain major decisions have to be approved by a special majority of 75% or 90% of the shareholders by value. This may not be an effective safeguard where the dominant shareholders hold a large majority of the shares so that they need to get the approval of only a small chunk of minority shareholders to reach the 75% level. Even otherwise, it may not be a sufficient safeguard if the process of conducting shareholder meetings is not conducive to broader participation by a large section of the shareholding public. The Indian system does not allow for postal ballots. Effective participation by small shareholders is possible only if there is a cost effective way of waging a proxy campaign. This would enable dissenting shareholders to collect proxies from others and prevent measures which are prejudicial to the minority shareholders.
III. Information disclosure and audit
Company law provides for regular accounting information to be supplied to the shareholders along with a report by the auditors. It also requires that when shareholder approval is sought for various decisions, the company must provide all material facts relating to these resolutions including the interest of directors and their relatives in the matter. Disclosure does not by itself provide the means to block the dominant shareholders, but it is a prerequisite for the minority shareholders to be able to exercise any of the other means available to them. Disclosure is also a vital element in the ability of the capital market to exercise its discipline on the issuers of capital.
IV. Voting Rights
(i) Ten percent: The approval of at least 10% of the shareholders is required for the requisition of an extraordinary general meeting for an application to the Company Law Board (CLT) for relief, if there is oppression or mismanagement (as defined in the Companies Act, 1956 by the majority shareholders.
(ii) Fifty-one percent: The approval of a minimum of 50% of the shareholders is required for an ordinary resolution, including for alteration of the share capital; declaration of dividend; election, removal, and remuneration of directors; approval of annual accounts; appointment of external auditors; appointment of other officers; and other routine matters relating to the conduct of a company.
(iii) Seventy-five percent: At least 75% of the shareholders must approve a matter before it is passed as a special resolution, including for capital increases, alteration in the memorandum and articles of the company, changing the registered office address of the company from one state to another, change in the name of the company, buy-back of shares, proposed mergers or liquidation. Therefore, a minority shareholder with more than 25% voting rights would have the ability to block special resolutions.
V. Qualified Minority
Minority shareholders with qualified minority may initiate action against decisions of the majority in a court of law. According to section 399 of the act, a qualified minority consists of at least one hundred shareholders or one tenth of the total number of shareholders, whichever is less, or any shareholder(s) holding one-tenth of the issued share capital of the company fully paid-up. Moreover, minority shareholders who hold more than 25% of the shares will have the ability to obstruct special resolutions, seek intervention of the CLT and, therefore, impede the functioning of the company at some level.
VI. Company Law Tribunal (CLT)
The Indian company law shields minorities’ interest by providing an adequate platform at CLT to raise grievances in case of oppression or mismanagement by the majority shareholders of a company. In circumstances when the minority is forced to exit the company by way of offering a nominal value for the shares held by them, the minority shareholders can approach the CLT to seek appropriate relief. The latter, if satisfied, has the power to intervene in the decisions of the majority shareholders. The CLT can order the majority shareholders to purchase the shares of the minority shareholders at a fair price. Further, if the minority shareholders wish to continue to be stakeholders in the company and do not want to sell their shares, they can obtain an injunction from CLT prohibiting the majority shareholders or acquirer from taking any action that may be averse to their interest.
VII. Minority Representation
It is important for Corporations to ensure that board membership reflects the interest of minority shareholders. In this regard, the Independent Directors (IDs) have an important role to play in ensuring minority shareholders’ interests are protected. The IDs also need to be easily accessible for minority shareholders to convey or raise their concerns. Minority shareholders can also nominate candidates for the ID position.
Historically, most matters relating to the rights of shareholders were governed by the company law. Over the last few decades, in many countries, the responsibility for protection of investors has shifted to the securities law and
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