Institutions such as a state, or corporations require a governing structure with a set of rules for the smooth running and fair distribution of benefits among its stakeholders. These institutions when manned by people from different cultural background creates complexities for governance. While no culture will support any wrongdoing e.g., fraud, the lack of comprehension in certain areas and strong cultural bias in some areas may make it easier to perpetuate poor governance. E.g., inheritance within family to the male members may allow business to pass from one generation to the next but also create governance issues if there are other shareholders. While family run businesses are still evolving- some of them run the company assuming they are the only owners and not consider the needs of other investors in the company.
Corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled. It essentially involves balancing the interests of a company's many stakeholders, such as shareholders, senior management executives, customers, suppliers, financiers, the government, and the community. Bad corporate governance can cast doubt on a company's operations, its ultimate profitability and how the profit is distributed. Thus, investors that ignore governance and chase the returns of such companies are taking an undue risk. For India to grow economically and attract capital, it needs good institutions and governance.
As some of you are aware, Quantum Advisors has since 1996 used an Integrity Filter (aka “Governance”) that precludes our investing in such companies on your behalf. This is not simply a moralistic exercise but simply a reflection of our recognition that companies that do not put shareholder rights as their #1 governance issue put their investors at economic risks, they often mask through short-term accounting mechanisms, inefficient board structures, multi-share classes and often outright unethical behaviour. While we avoided many large groups with suspect practices, we made our share of mistakes and learnt from them. We have written on corporate governance in past years (read more: Active Engagements in Corporate Governance), but think a refresher is worthwhile.
US investors will be aware of major failures of corporate governance, such as WorldCom and Enron. In 2001, Enron filed for bankruptcy when massive trading losses could no longer be hidden. Executives used its complex business model and unethical practices to misrepresent earnings and modify the balance sheet to indicate favourable performance. In 2002, an internal WorldCom audit uncovered a scheme to inflate earnings to prop up the company’s stock price. Eventually, WorldCom was forced to admit that it had overstated its assets by over $11 billion. Estimated stockholder losses from these 2 cases alone exceeded $200 Billion. It also led to many criminal convictions and spawned new regulations in the US, such as Sarbanes-Oxley.
European investors will be familiar with the Volkswagen scandal, sometimes known as “Dieselgate” or “Emissions gate”. In 2015, the United States Environmental Protection Agency issued the company a notice of violation of the Clean Air Act. The company was found to have intentionally installed devices to cheat on vehicle emissions testing that is required in the US. While Volkswagen stock price has rebounded, in the 2 months following the violation, the company lost $46 Billion in value. They may also be familiar with Germany’s Wirecard bankruptcy in 2020, following the uncovering of ‘missing’ funds. Despite allegations of accounting irregularities going back to 2008, the company was included in the DAX Index.
Investors in Indian markets may recall the Satyam Computer Services fraud that was unmasked in the wake of the US Lehman collapse affected Global Financial Crisis, whereas the firm were found to have reported profits that never existed, which was not uncovered by PwC, their auditor. Much of the missing cash was invested in property. The swindle was discovered in late 2008 when the property market collapsed in a city in south India, leaving a trail back to Satyam.
ILFS fraud was the largest corporate fraud in India, which came to light in July 2018 when two of IL&FS’s subsidiaries failed to pay back loans and inter corporate deposits to certain banks and lenders. This uncovered deliberate accounting fraud, such as evergreening of loans. ILFS balance sheet size at the time of the fraud was USD 12 bn and its collapse had a serious impact on the credit market.
The above are just a few global examples of real economic losses, focused on outright fraud. Most of these and other cases are avoidable with proper governance structures. One must focus on a real independent board of directors, shareholder committees, accounting and audit oversight and transparency into business practices.
In India, some of the largest, most well-known, index included names which lack these basic functions. Some of them have relied on years of so-called Crony Capitalism, whereby business contracts are won, or permissions gained, based solely on their government ties. Additionally, they rely on a series of complex corporate structures and accounting practices that might propel their earnings, and therefore, stock prices for some time. The structures mask significant economic risks. As we know from reviewing past poor-governance related collapses, about which we gave a mere few examples, when such companies do run into business challenges their collapse can seem fast and furious, but in hindsight the signs were always there.
Most of you are aware, we do not manage to an index but provide you comparisons thereto for informational purposes. We are proud that our long-term value strategy has outperformed our benchmarks, but also recognize that in recent years avoidance of some larger India companies that are index included, as noted above, have cost us some basis points. But we remain convinced that not only does using a Governance filter mean we are ‘doing the right thing’ but also avoiding putting your capital at serious long-term risks just to look comparatively better on some peer stat sheets.