Corporate Governance and the Role of Institutional Investors

8/12/2019 Corporate Governance and the Role of Institutional Investors

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Corporate Governance and

The Role InstitutionalInvestors

Legal Aspects of Business Assignment

Sarita Meena

Section D2013PGP351

3/21/2014


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Contents

Contents................................................................................................................................. 2

Institutional Investors and Corporate Governance in India.....................................................3

Introduction: ...........................................................................................................................3

Corporate governance in india................................................................................................6

Regulatory Framework for Corporate Governance in India.................................................

!nforcement of Corporate Governance "orms...................................................................#

$ey Issues in Corporate Governance in India % &anaging t'e (ominant )'are'older*s+

and t'e ,romoter*s+..........................................................................................................-

!nforcement for non/compliance of Corporate Governance "orms..................................-3

Companies 0ill1 2-- and its Impact on Corporate Governance in India...........................-

Institutional investors............................................................................................................-

4opology of t'e institutional investors5 community in India................................................-

(evelopment Financial Institutions....................................................................................-

)tate/owned insurance companies...................................................................................-#

,rivate sector insurance companies.................................................................................2

&utual funds and FIIs.......................................................................................................2-

egal and regulatory framework for Institutional Investors....................................................22

Institutional )tructure of Regulation..................................................................................22

0anks and (FIs................................................................................................................22

Insurance companies........................................................................................................22

&utual Funds and Foreign Institutional Investors..............................................................22

,ension Funds Industry....................................................................................................27

0oard representation8Clause 7#.......................................................................................2Independent (irectors.......................................................................................................2

"ominee (irectors............................................................................................................26

Role of Institutional Investors................................................................................................2#

4'e role of institutional investors in ot'er countries:.............................................................33

&andate for Conflicts of interests in 9!C( Countries:......................................................3

,olicy recommendations...................................................................................................... 36

References:......................................................................................................................7

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Institutional Investors and Corporate Governance in India

Introduction:

The Report falls within the framework of cooperation on matters of corporate governance

Its mandate is to increase awareness of good corporate governance practices through

workshops and seminars, sponsor academic research, and set up a training program for board

members

The 2004 CG R!C assessment conducted b" the #orld $ank benchmarks India%s corporate

governance framework to the &C' (rinciples of Corporate Governance )The &C'

(rinciples*+ It focuses on the rights of shareholders, the euitable treatment of shareholders,

the role of stakeholders, disclosure and transparenc", and the duties of the board of listed

companies+ The assessment found that over the last decade or so, a series of legal and

regulator" reforms have improved the Indian corporate governance framework markedl"- the

level of responsibilit" and accountabilit" of insiders have been strengthened, fairness in the

treatment of minorit" shareholders has been enhanced, together with board practices, and

transparenc"+ .onetheless, enforcement and implementation of laws and regulations remain

important challenges+

The areas flagged as a high priorit" for India in the CG R!C assessment were/

a* the compliance b" corporations with the new corporate governance framework and the

need for strict enforcement b" regulators for corporate governance violations-

b* the clarification of regulator" and supervisor" responsibilities between the securities

regulator and the stock echanges as far as monitoring and surveillance-

c* the role of institutional investors in the corporate governance of their portfolio companies

and the need for more transparenc" on their policies on corporate governance and voting

decisions- and

d* the creation of a credible directors% training institution+

The rationale underl"ing the polic" recommendations is that increased monitoring of Indian

listed corporations b" institutional investors will drive the former to enhance their corporate

governance practices, and ultimatel" their abilit" to generate better financial results and

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growth for their investors+ (ositive eternalities for the whole corporate sector can also be

epected+

$ased on the eperience of countries where shareholders activism is vibrant, such as for

eample 1ustralia, rance, the 3, or the 3nited !tates, it is reasonable to epect that Indian

institutional investors could in some circumstances, enhance the value of their portfolio b"

undertaking a reasonable amount of anal"sis and b" using their ownership rights more

activel"+ ailure to eercise their ownership rights ma" in some cases result in a loss for their

investors+ The purpose of the polic" recommendations is therefore to encourage institutional

investors to factor such value enhancements5losses in their costs5benefits anal"sis+ In

addition, institutional investors, especiall" those acting in a fiduciar" capacit", are better

positioned than retail investors to pla" a monitoring role in their portfolio companies because

the" do not face the collective action )free6rider* problem to the same etent+

The polic" recommendations focus eclusivel" on the role of institutional investors in the

corporate governance of their portfolio companies+ The" do not address the more comple

issue of the corporate governance of institutional investors themselves which was not part of

the #orld $ank mandate+

$ased on the findings from two uestionnaires sent to institutional investors and companies,

complemented b" interviews with market participants, it was found that most domestic

mutual funds take a passive role in the corporate governance of their portfolio companies+

The" seldom if ever review the agenda of shareholders meetings, do not attend shareholders

meetings, and do not eercise their voting rights, unless something goes drasticall" wrong, or

if a takeover situation occurs+ .or do the" disclose their voting records+ oreign institutional

investors tend to eercise their ownership rights more activel"+ Insurance companies and

banks are somewhat more active than domestic mutual funds but less active then foreign

institutional investors+ The latter institutions do attend shareholders meetings, vote at

shareholders meetings or through postal ballot and convene informal meetings with

management on an ad hoc basis, but like the first group, the" support incumbent

management+ The" sometimes consult with other institutional investors+

The polic" recommendations address four main issues/

)7* the disclosure b" institutional investors of their corporate governance and voting policies

and voting records-

)2* the disclosure of material conflicts of interests which ma" affect the eercise of ke"

ownership rights-

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)8* measures to facilitate the eercise of shareholders rights b" institutional investors- and )4*

the practice of nominee directors+ In addition, it is recommended that the GI urgentl"

focuses on the corporate governance of institutional investors themselves+

The remainder of the paper contains four sections+ !ection II below identifies the various

t"pes of institutional investors active in the Indian market+ It includes a brief summar" of the

historical contet in which the" have evolved and provides recent statistical information on

their assets under management, their relative si9e, and historical growth+

!ection III summari9es the legal and regulator" framework governing the various t"pes

of institutional investors operating in the Indian market, together with a summar" of the

relevant sections of Clause 4: and a discussion on nominee directors+ !ection ; sets out the

polic" recommendations+

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Corporate governance in india

Corporate governance in India gained prominence in the wake of liberali9ation during the

7::0s and was introduced, b" the industr" association Confederation of Indian Industr" )CII*,

as a voluntar" measure to be adopted b" Indian companies+ It soon acuired a mandator"

status in earl" 2000s through the introduction of Clause 4: of the owever in a parallel process, ke" corporate governance norms are

currentl" being consolidated into an amendment to the Companies 1ct, 7:?@ and once the

Companies $ill,2077 is approved the corporate governance reforms in India would have

completed two full c"cles 6 moving from the voluntar" to the mandator" and then to the

voluntar" and now back to the mandator" approach+

The 1nglo6!aon model of governance, on which the corporate governance framework

introduced in India is primaril" based on, has certain limitations in terms of its applicabilit"

in the Indian environment+ or instance, the central governance issue in the 3! or 3 is

essentiall" that of disciplining management that has ceased to be effectivel" accountable to

the owners who are dispersed shareholders+

>owever, in contrast to these countries, the main issue of corporate governance in India is

that of disciplining the dominant shareholder, who is the principal block6holder, and of

protecting the interests of the minorit" shareholders and other stakeholders+

This issue and the compleit" arising from the application of alien corporate governance

model in the Indian corporate and business environment is further compounded b" the weak

enforcement of corporate governance regulations through the Indian legal s"stem+

urthermore, given that corporate governance is essentiall" a soft issue, whose essence

cannot be captured b" uantitative and structural factors alone, one of the challenges of

making corporate governance norms mandator" is the need to differentiate between form and

content- for instance, how do we determine whether companies actuall" internali9e the

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desired governance norms or whether the" look at governance as a check6the6bo eercise to

be observed more in letter than in spirit+

Currentl", corporate governance reforms in India are at a crossroads- while corporate

governance codes have been drafted with a deep understanding of the governance standards

around the world, there is still a need to focus on developing more appropriate solutions that

would evolve from within and therefore address the India6specific challenges more

efficientl"+

Corporate governance is perhaps one of the most important differentiators of a business that

has impact on the profitabilit", growth and even sustainabilit" of business+ It is a multi6level

and multi6tiered process that is distilled from an organi9ation%s culture, its policies, values

and ethics, especiall" of the people running the business and the wa" it deals with various

stakeholders+

Creating value that is not onl" profitable to the business but sustainable in the long6term

interests of all stakeholders necessaril" means that businesses have to runAand be seen to be

runAwith a high degree of ethical conduct and good governance where compliance is not

onl" in letter but also in spirit+

Regulatory Framework for Corporate Governance in India

1s a part of the process of economic liberali9ation in India, and the move toward further

development of India%s capital markets, the Central Government established regulator"

control over the stock markets through the formation of the !&$I+ riginall" established asan advisor" bod" in 7:BB, !&$I was granted the authorit" to regulate the securities market

under the !ecurities and &change $oard of India 1ct of 7::2 )!&$I 1ct*+

(ublic listed companies in India are governed b" a multiple regulator" structure+ The

Companies 1ct is administered b" the =inistr" of Corporate 1ffairs )=C1* and is currentl"

enforced b" the Compan"


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government bod" charged with administering the Companies 1ct of 7:?@, while !&$I has

served as the securities market regulator since 7::2+

!&$I serves as a market6oriented independent entit" to regulate the securities market akin to

the role of the !ecurities and &change Commission )!&C* in the 3nited !tates+ The stated

purpose of the agenc" is to protect the interests of investors in securities and to promote the

development of, and to regulate, the securities market+ The realm of !&$I%s statutor"

authorit" has also been the subect of etensive debate and some authors have raised doubts

as to whether !&$I can make regulations in respect of matters that fall within the urisdiction

of the 'epartment of Compan" 1ffairs+ !&$I%s authorit" for carr"ing out its regulator"

responsibilities has not alwa"s been clear and when Indian financial markets eperienced

massive share price rigging frauds in the earl" 7::0s, it was found that !&$I did not have

sufficient statutor" power to carr" out a full investigation of the frauds+ 1ccordingl", the

!&$I 1ct was amended in order to grant it sufficient powers with respect to inspection,

investigation, and enforcement, in line with the powers granted to the !&C in the 3nited

!tates+

1 contentious aspect of !&$I%s power concerns its authorit" to make rules and regulations+

3nlike in the 3nited !tates, where the !&C can point to the !arbanes6le" 1ct, which

specificall" confers upon it the authorit" to prescribe rules to implement governance

legislation, !&$I, on the other hand, cannot point to a similar piece of legislation to support

the imposition of the same reuirements on Indian companies through Clause+ Instead !&$I

can look to the basics of its own purpose, as given in the !&$I 1ct, wherein it is granted the

authorit" to Dspecif", b" regulations, the matters relating to issue of capital, transfer of

securities and other matters incidental thereto + + + and the manner in which such matters shall

be disclosed b" the companies+E In addition, !&$I is granted the broad authorit" to Dspecif"

the reuirements for listing and transfer of securities and other matters incidental thereto+E

Recogni9ing that a problem arising from an overlap of urisdictions between the !&$I and

=C1 does eist, the !tanding Committee, in its final report, has recommended that while

providing for minimum benchmarks, the Companies $ill should allow sectoral regulators like

!&$I to eercise their designated urisdiction through a more detailed regulator" regime, to

be decided b" them according to circumstances+ Referring to a similar case of urisdictional

overlap between the R$I and the =C1, the Committee has suggested that it needs to be

appropriatel" articulated in the $ill that the Companies 1ct will prevail onl" if the !pecial

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1ct is silent on an" aspect+ urther the Committee suggested that if both are silent, reuisite

provisions can be included in the !pecial 1ct itself and that the status uo in this regard ma",

therefore, be maintained and the same ma" be suitabl" clarified in the $ill+ This, in the

Committee%s view, would ensure that there is no urisdictional overlap or conflict in the

governing statute or rules framed there under+

Enforcement of Corporate Governance Norms

The issue of enforcement of Corporate Governance norms also needs to be seen in the

broader contet of the substantial dela" in the deliver" of ustice b" the Indian legal s"stem

on account of the significant number of cases pending in the Indian courts+ 1 research paper

b" (R! igh Courts had remained unresolved for more than ten "ears and

in 200@, 0 per cent of all prisoners in Indian ails were under trials+ !ince fresh casesoutnumber those being resolved, there is obviousl" a shortfall in the deliver" of ustice, and a

conseuent increase in the number of pending cases+ In addition, the weight of the backlog of

older cases creeps upward ever" "ear+ This backlog in the Indian udicial s"stem raises

pertinent uestions as to whether the current regulator" framework in India, as enacted, is

adeuate to enable shareholders to recover their ust dues+ This concern is also articulated in

the recent pleadings )filed in Fanuar" 2070* in the 3nited !tates 'istrict Court, !outhern

'istrict of .ew Hork, on the matter relating to the fraud in the erstwhile !at"am Computer

!ervices,8B wherein 3!6based investors were seeking damages from defendants that

included, among others, !at"am and its auditors, (ricewaterhouseCoopers )(wC* and has

thrown up some ver" interesting and relevant issues+ This case was filed on behalf of

investors who had purchased or otherwise acuired !at"am%s 1merican 'epositor" !hares

)1'!* listed on the .ew Hork !tock &change and investors, residing in the 3nited !tates,

who purchased or otherwise acuired !at"am common stock on the .ational !tock &change

of India or the $omba" !tock &change+ In their pleadings, the plaintiffs submitted

declarations of two prominent Indian securities law eperts/ !andeep (arekh, former

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&ecutive 'irector of !&$I, and (rofessor ;ikramadit"a hanna of the 3niversit" of

=ichigan


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actuall" between maorit" shareholders and other stakeholders+ !econdl", much of global

corporate governance norms focus on boards and their committees, independent directors and

managing C& succession+ In the Indian business culture, boards are not as empowered as in

several western economies and since the board is subordinate to the shareholders, the will of

the maorit" shareholders prevails+

Therefore, most corporate governance abuses in India arise due to conflict between the

maorit" and minorit" shareholders+ This applies across the spectrum of Indian companies

with dominant shareholdersA(!3s )with government as the dominant shareholder*,

multinational companies )where the parent compan" is the dominant shareholder* and private

sector famil"6owned companies and business groups+

In public sector units (PSUs),members of the board and the Chairman are usuall" appointed

b" the concerned ministr" and ver" often (!3s are led b" bureaucrats rather than

professional managers+ !everal strategic decisions are taken at a ministerial level which ma"

include political considerations of business decisions as well+ )The recent case of the (!3 oil

companies not being allowed to increase the price of oil products in line with the changes in

the international crude prices is an eample of how the dominant shareholder, the Indian

Government, uses its dominance to force decisions that are not alwa"s linked to business

interests+* Therefore, (!3 boards can rarel" act in the manner of an empowered board as

envisaged in corporate governance codes+

This makes several provisions of corporate governance codes merel" a compliance

eercise+

Multinational companies (MNCs)in India are perceived to have a better record of corporate

governance compliance in its prescribed form+ >owever, in the ultimate anal"sis, it is the writ

of the large shareholder )the parent compan"* which runs the Indian unit that holds swa",

even if it is at variance with the wishes of the minorit" shareholders+ =oreover, the

compliance and other functions in an =.C is alwa"s geared towards laws applicable to the

parent compan" and compliance with local laws is usuall" left to the managers of the

subsidiar" who ma" not be empowered for such a role+

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Family businesses and business groupsas a categor" are perhaps the most comple for

anal"sing corporate governance abuses that take place+ The position as regards famil"

domination of Indian businesses has not changed- on the contrar", over the "ears, families

have become progressivel" more entrenched in the Indian business milieu+ 1s per a recent

stud" b" the global financial maor Credit !uisse, India ranks higher than most 1sian

economies in terms of the number of famil" businesses and the market capitali9ation of

Indian famil" businesses as a share of the nominal gross domestic product )G'(* has risen

from : per cent in 2007 to 4@ per cent in 2070+ This surve", which also covered China, !outh

orea, Taiwan, !ingapore, Thailand, >ong ong, Indonesia, =ala"sia and the (hilippines,

contends that India, with a @ per cent share of famil" businesses, ranks first among the ten

1sian countries studied+ urthermore, @@8 of the :B8 listed Indian companies are famil"

businesses and account for half of the total corporate hiring and are concentrated in the

consumer discretionar", consumer staples and consumer healthcare sectors+

In addition to the corporate governance issues arising from the dominant famil" holding in

the Indian business companies, there eists an additional compleit" on account of the

promoter controlin Indian companies+ Promoters )who ma" not be holding is not to be

included in the definition of the (romoter+ Indian law and regulation reuire that controlling

shares* usuall" eercise significant influence on matters involving their companies, even

though such companies are listed on stock echanges and hence have public shareholders+

(romoters ma" be in control over the resources of the compan" even though the" ma"

not be the maorit" shareholders and, because of their position, have superior information

about the affairs of the compan" than that accessible to non6promoters+ 1s a corollar", in an

organi9ation, promoters and non6promoters constitute two distinct groups that ma" have

diverse interests+

The !at"am episode illustrated a scenario wherein a compan" with minimal promoter

shareholding could still be subect to considerable influence b" its promoters, thereb"

reuiring a resolution of the agenc" problem between the controlling shareholders and the

minorit" shareholders, even though such problems were not normall" epected to arise at the

low shareholding levels of the managing group+ n Fanuar" 200:, when the Chairman of

!at"am Computer !ervices, $+ Ramalinga Rau, admitted that there had been a s"stematic

inflation of cash on the compan"%s balance sheet over a period of some seven "ears,

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amounting to almost K7+? billion, the Rau famil", who were the promoters of !at"am, held

onl" about ? per cent of the shares+

1 compan" with ? per cent promoter shareholding will usuall" be considered as belonging to

the outsider model in terms of diffused shareholding, and hence would reuire the correction

of agenc" problems between shareholders and managers+ >owever, despite the gradual

decrease in the percentage holdings of the controlling shareholders, the concept of Jpromoter%

under Indian regulations made the distinction between an insider6t"pe compan" and an

outsider6t"pe compan" somewhat ha9" in this contet, and the Rau famil", as promoters,

continued to wield significant powers in the management of the compan" despite a drastic

drop in their shareholdings over the preceding few "ears+ urthermore, at !at"am, the

diffused nature of the remaining shareholding of the compan" helped the promoter group to

consolidate and eercise power that was disproportionate to their voting rights- while the

institutional shareholders collectivel" held a total of @0 per cent shares as of 87 'ecember

200B in !at"am, the highest individual shareholding of an institutional shareholder was

onl"+@ per cent+ !hah believes that companies wherein controlling shareholders hold limited

takes could be particularl" vulnerable to corporate governance failures and adds that

promoters who are in the twilight 9one of control, that is, where the" hold shares less than

those reuired to comfortabl" eercise control over the compan", have a perverse incentive to

keep the corporate performance and stock price of the compan" at high levels so as to thwart

an" attempted takeover of the compan"+ The !at"am case clearl" demonstrates the inabilit"

of the eisting corporate governance norms in India to deal with corporate governance

failures in famil"controlled companies, even where the level of promoter shareholding is

relativel" low+

uture governance reforms thus need to address the matter of promoters with minorit"

shareholding, who are in effective control of managements in such companies that lie at the

cusp of insider and outsider s"stems+

Enforcement for non'compliance of Corporate Governance Norms

#hile much has been talked on the polic" aspect of the Corporate Governance, at present

monitoring of the compliance of the same is done onl" through disclosures in the annual

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report of the compan" and periodic disclosures of the various clauses of Clause 4: of the


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'elisting or suspension is generall" not considered an investor friendl" action and therefore,

cannot be resorted to as a matter of routine and can be used onl" in cases of etreme 5

repetitive non6compliance+ (rosecution, on the other hand, is a costl" and time6consuming

process+

In order to strengthen the monitoring of the compliance, following measures ma" be

considered/

Carr"ing out of Corporate Governance rating b" the Credit Rating 1gencies+

Inspection b" !tock &changes5 !&$I5 or an" other agenc" for verif"ing the

compliance made b" the companies+

Imposing penalties on the Compan"5its $oard of 'irectors5Compliance fficer5e"=anagerial (ersons for non6compliance either in sprit or letter (resentl", provisions

of listing agreement are being converted into Regulations for better enforcement+

Companies (ill) *+,, and its Impact on Corporate Governance in India

The foundations of the comprehensive revision in the Companies 1ct, 7:?@ was laid in 2004

when the Government constituted the Irani Committee to conduct a comprehensive review of

the 1ct+ The Government of India has placed before the (arliament a new Companies $ill,

2077 that incorporates several significant provisions for improving corporate governance in

Indian companies which, having gone through an etensive consultation process, is epected

to be approved in the 2072 $udget session+ The new Companies $ill, 2077 proposes

structural and fundamental changes in the wa" companies would be governed in India and

incorporates various lessons that have been learnt from the corporate scams of the recent

"ears that highlighted the role and importance of good governance in organi9ations+

!ignificant corporate governance reforms, primaril" aimed at improving the board oversight

process, have been proposed in the new Companies $ill- for instance it has proposed, for the

first time in Compan"


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on the compan" and all its members+ The enhanced investor protection framework, proposed

in the $ill, also empowers small shareholders who can restrain management from actions that

the" believe are detrimental to their interests or provide an option of eiting the compan"

when the" do not concur with proposals of the maorit" shareholders+

The Companies $ill, 2077 seeks to provide clarit" on the respective roles of !&$I and the

=C1 and demarcate their roles M while the issue and transfer of securities and non6pa"ment

of dividend b" listed companies or those companies which intend to get their securities listed

shall be administered b" the !&$I all other cases are proposed to be administered b" the

Central Government+ urthermore, b" focusing on issues such as &nhanced 1ccountabilit" on

the part of Companies, 1dditional 'isclosure .orms, 1udit 1ccountabilit", (rotection for

=inorit" !hareholders, Investor (rotection, !erious raud Investigation ffice )!I* in the

new Companies $ill, 2077, the =C1 is epected to be at the forefront of Corporate

Governance reforms in India+

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IN#-I-.-I/N01 IN2E#-/R#

-opology of t!e institutional investors3 community in India

"evelopment Financial Institutions

!tarting in 7:4B and throughout the 7:?0s and 7:@0s, the Government of India )GI*

established three 'evelopment inancial Institutions )'Is* to cater to the long6term finance

needs of the countr"%s industrial sector+ These were ICI, the first 'I set up in 7:4B, ICICI,

established in 7:?? and I'$I, which was established in 7:@4+ The Reserve $ank of India

)R$I* and the GI nurtured these three 'Is through financial incentives and othersupportive polic" measures+ The" were provided with low6cost funds which the" on6lent to

industr" at subsidi9ed rates+ The" were also allowed to issue bonds guaranteed b" the

Government+ The Reserve $ank of India )R$I* allocated a substantial part of its .ational

Industrial Credit )


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Two other maor groups of Government6owned financial institutions have had a maor impact

on euit" investment trends in India+ The first group consists of state6owned life and non6life

insurance corporations- the second group is made up of the public sector mutual funds+

#tate'owned insurance companies

The nationali9ation of insurance business in India resulted in the establishment of the


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&rivate sector insurance companies

In 7::8, the =alhotra Committee was set up to evaluate the insurance industr" and

recommend future directions+ The committee submitted its report in 7::4+ Its maor

recommendations included

)i* reduction of Government shareholding in the state owned insurance companies to

?0 percent, and a break up of GIC-

)ii* allowing private companies with a minimum paid up capital of I.R 7 billion to

enter industr", as well as foreign companies in collaboration with domestic

companies- and)iii* setting up an insurance regulator" bod"77+ In 2000, GIC%s supervisor" role over

its subsidiaries was etinguished and GIC was re6designated DIndian Re6insurerE

to function eclusivel" as life and non6life re6insurer+ In =arch 2002, GIC ceased

to be a holding compan" for its subsidiaries and their ownership was vested with

the Government of India+

In 1pril 2002, the Insurance Regulator" and 'evelopment 1uthorit" )IR'1* came into

being+ IR'1 is responsible for registering private insurance companies and framing

regulations for the industr"+

The Insurance Regulator" and 'evelopment 1uthorit" )IR'1* 1ct allows foreign companies

a 2@ percent euit" stake in Indian insurance companies+ 1s on Fune 200?, there were 74 life

insurance companies, 74 non6life insurance companies, and one reinsurer )GIC* registered

with IR'1+ The 'C* has an 7B+@0 percent foreign shareholder, and !ahara India is wholl"

Indian owned+ !even of the eight private companies in the general insurance sector have

foreign euit" holdings of 2@ percent+ The onl" one that does not is Reliance General

Insurance Co+


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:?+2: percent of the market share while the private sector had ust 4+7 percent+ In the non6

life segment, the new insurers held a market share of 78 percent+

utual funds and FIIs

The Indian mutual fund industr" came into being in 7:@8 with the formation of 3nit Trust of

India, at the initiative of the Government of India and R$I+ The histor" of mutual funds in

India can be broadl" divided into four distinct phases7@+ In the first phase from 7:@4 to 7:B,

3TI was the onl" mutual fund operating in India+ In the second phase between 7:B and

7::8, public sector banks and insurance companies were permitted to set up mutual funds+

!tate $ank of India, (unab .ational $ank, Canara $ank, Indian $ank, $ank of $aroda,

$ank of India,


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1EG01 0N" REG.10-/R4 FR0E5/RK F/R

IN#-I-.-I/N01 IN2E#-/R#

Institutional #tructure of Regulation

(anks and "FIs

$anks and 'Is fall under the oversight of the R$I, with an implicit regulator" role pla"ed

b" the =inistr" of inance+ The main legislation governing banks and 'Is is the Reserve

$ank 1ct, 7:84 and the $anking Regulation 1ct )7:4:*+ 1s discussed in the previous

sections, the 1cts of (arliament governing I'$I and 3TI were repealed in 2002 and 2004 to

facilitate conversion of I'$I into a banking entit" and into market6linked mutual fund

respectivel"+

Insurance companies

In the insurance sector, the two largest government6owned insurance companies6


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!&$I+ The code of conduct la"s out the broad principles of proper business conduct and

functioning of the intermediaries+

In 7::@, all mutual funds ecept 3TI came within the purview of the !&$I )=utual und*

Regulations, 7::@+ 3TI which was set up under an 1ct of (arliament was not under the

regulator" purview of !&$I until 2002 when the 3TI 1ct was repealed and the fund was split

into 3TI6I and 3TI6II+ Thereafter, 3TI I and II were brought under the regulator" purview of

!&$I+

The 1ssociation of =utual unds of India )1=I* is the self6regulator" organi9ation )!R*

set up in 7::+ It is involved in

a* recommending and promoting best business practices and code of conduct to be followed

b" mutual funds- and

b* interacting with !&$I on all matters concerning the industr"+ In addition 1=I is

addresses specific technical issues faced b" the mutual fund industr" such as developing

valuation norms for illiuid securities+ 1mongst other activities conducted b" the 1=I are

administering the certification eaminations for persons involved in the mutual fund industr"

which includes emplo"ees of the asset management companies and the various brokers,

distributors of mutual fund products+ The 1=I is also involved in investor education and

awareness building+

!&$I issued the II regulations in .ovember 7::?, based on guidelines issued b" the GI in

7::2+ The regulations mandate the registration of foreign institutional investors with !&$I+

The IIs were initiall" permitted access to primar" and secondar" markets for securities and

mutual fund products, with a stipulated minimum 0 percent investment in euit"+ The initial

ceilings on the ownership of an" firm were ? percent for a single II and 24 percent for all

IIs taken as a group+ Individual ceiling on ownership has been eased to 70 percent since

ebruar" 2000, and the overall ceiling for all IIs was removed in !eptember 2007 in favor

of sectoral caps subect to shareholder resolution+ IIs have also been permitted to invest in

corporate and government bonds, and in derivative securities+ urther, foreign firms and

individuals have been permitted access to the Indian markets through IIs as Dsub6accountsE

since ebruar" 2000+ In the "ear 2008, earlier limitations on II hedging currenc" risk using

currenc" forwards were removed, and II approval was streamlined and vested solel" in

!&$I, instead of !&$I and R$I as reuired earlier+

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24/47

&ension Funds Industry

1 new 'efined Contribution pension s"stem has been introduced, which is applicable to all

Government emplo"ees recruited after Fanuar" 7, 2004+ This .ew (ension !"stem will be

regulated b" (ension und Regulator" and 'evelopment 1uthorit" )(R'1* promulgated

through an ordinance on 'ecember 80, 2004+ The (R'1%s role is to license and supervise

pension fund managers, la" down guidelines on the number of market participants, prudential

norms, investment criteria and capital reuirements of pension fund managers+ (R'1 is

also epected to issue 'I caps for the pension sector+

It is epected that initial investments in euit" will be somewhat limited+ 1ll pre6Fanuar"

2004 emplo"ees can also voluntaril" oin the new scheme to get an additional benefit+

!imilarl", all those covered b" the &mplo"ees (rovident und )&(* will continue in it, but

can voluntaril" oin the new scheme to+ To a large etent, the new pension schemes will

resemble mutual funds, and subscribers will have a choice of parking their savings

)a* predominantl" in euit",

)b* debt N euit" mi, or

)c* entirel" in debt instruments and Government paper+

=an" of the maor pla"ers in the mutual fund and the insurance industr" are set to enter the

pension sector, epected to grow to I.R ?00 billion b" 2070+

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25/47

(oard representation6Clause 78

The regulator" framework governing the boards of directors of Indian corporations is set out

in Chapter II )sections 2?2 to 2@:* of the Companies 1ct, 7:?@+ In addition, Clause 4: of the


26/47

)c* has not been an eecutive of the compan" in the immediatel" preceding three financial

"ears-

)d* is not a partner or an eecutive of the statutor" audit firm or the internal audit firm that is

associated with the compan", and has not been a partner or an eecutive of an" such firm for

the last three "ears+ This will also appl" to legal firm)s* and consulting firm)s* that have a

material association with the entit"-

)e* is not a supplier, service provider or customer of the compan"+ This should include lessor6

lessee t"pe relationships also- and

)f* is not a substantial shareholder of the compan", i+e+ owning two percent or more of the

voting shares+ It also caps to three terms of three "ears the mandates of independent directors+

Nominee "irectors

1s discussed earlier, a series of 'Is were created b" 1cts of (arliament to support the

development of industrial companies, b" etending loans to the latter or subscribing to

debentures issues+ To protect the public institutions% investments and euip it with effective

risk management tools, each founding 1ct of (arliament of the 'I stipulated that the latter

should insert two specific clauses in their loan agreements, s"stematicall"/

)7* a convertibilit" clause, which allowed the 'I to convert its loan5debenture into euit"and hence allowed the 'I to take control of the corporation*, if the compan" defaulted on its

debt obligation to the 'I- and

)2* a Dnominee director clauseE, which gave the 'I the right to appoint one or more

directors to the board of the borrowing compan"+

In =arch 7:B4, the $anking 'ivision of the =inistr" of inance, 'epartment of Compan"

1ffairs issued its (olic" Guidelines relating to !tipulation of Convertibilit" Clause and

1ppointment of .ominee 'irectors+ The guidelines specified that DI'$I, ICI, ICICI and

IRCI should create a separate Cell the eclusive and whole6time function of which would be

to represent the institutions on the $oards of Companies+ utsiders should be appointed as

nominee directors onl" as additional directors were needed+

.ominee directors should be appointed on the $oards of all =RT( companies assisted b" the

institutions+ 1s regard non6=RT( companies, nominee directors should be appointed on a

selective basis, especiall" when one or more of the following conditions prevail/

)a* the unit is running into problems and is likel" to become sick-

)b* institutional holding is more than 2@ percent- and

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27/47

)c* where the institutional stake b" wa" of loans5investment eceeds I.R ?0 million+

The Guidelines further stipulated that Dnominee directors should be given clearl" identified

responsibilities in a few areas which are important for public polic"E+ 1n illustrative list of

such responsibilities was provided, including /

)a* financial performance of the compan"-

)b* pa"ments of dues to the institutions-

)c* pa"ment of government dues, including ecise and custom duties, and statutor" dues-

)d* inter6corporate investment in and loans to or from associated concerns in which the

promoter group has significant interest-

)e* all transaction in shares-

)f* ependiture being incurred b" the compan" on management group- and

)g* policies relating to the ward of contracts and purchase and sale of raw materials, finished

goods, machiner", etc+

In addition the Guidelines specified that Dthe nominee directors should ensure that the

tendencies of the companies towards etravagance, lavish ependiture and diversion of funds

are curbed+

#ith a view to achieve this obect, the institutions should seek constitution of a small 1udit

sub6committee of the board of directors for the purpose of periodic assessment of ependiture

incurred b" the assisted compan", in all cases where the paid6up capital of the compan" is

I.R ?0 million or more+ The institutional nominee director will invariabl" be a member of

this 1udit !ub6committee+

Considering that the practice of audit committees onl" became accepted internationall" as

best practice in the late 7::0s, the =inistr" of inance )=* Guidelines were in some

respect ahead of their time+ >owever, !ection 80+1 of of the Industrial 'evelopment $ank of

India 1ct, )7:@4* stipulated that nominee directors would not

)7* be subect to Dthe provisions of the Companies 1ct, or to provisions of the memorandum,

articles of associations or an" other instrument relating to the industrial concern, nor an"

provisions regarding share ualifications, age6limit, number of directorships, or removal from

officeE- and

)2* incur an" obligation or liabilit" be reason onl" of his being a director or for an"thing done

or omitted to be in good faith in the discharge of his duties as a director or an"thing in

relation theretoE+ >ence, nominee directors were not ointl" and severall" responsible to

shareholders for the actions of the board+

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In 7::7, the =onopolies and Restrictive Trade (ractices 1ct, 7:@: )=RT( 1ct* was

amended+ (rovisions relating to concentration of economic power and pre6entr" restrictions

with regard to prior approval of the Central Government for establishing new undertaking,

epanding on eisting undertaking, amalgamations, mergers and takeovers of undertakings

were all deleted from the statute through the amendments+ The causal thinking in support of

the 7::7 amendments is contained in the !tatement of bects and Reasons appended to the

7::7 1mendment $ill in the (arliament47+

inall", in 'ecember 2008, the Industrial 'evelopment $ank )Transfer of 3ndertaking and

Repeal* 1ct, 2008 provided for the transfer and vesting of the undertaking of the Industrial

'evelopment $ank of India to, and in I'$I $ank+ >owever, !ection 7? of 1ct ?8

grandfathered the immunit" etended to nominee directors+ !pecificall", section 7? stipulated

that Dnotwithstanding the repeal of the Industrial 'evelopment 1ct, 7:@4, the provisions of

!ection 801 of the 1ct so repealed will continue to be applicable in respect of the

arrangement entered into b" the 'evelopment $ank with an industrial concern up to the

appointed da" and the Compan" OIndustrial 'evelopment $ank of IndiaP will be entitled to

act upon and enforce the same as full" and effectuall" as if this 1ct has nor been repealedE+

In 2008, The umara =angalam $irla Committee recommended that institutions should

appoint nominees on the boards of companies onl" on a selective basis, where such

appointment is pursuant to a right under loan agreements or where such appointment is

considered necessar" to protect the interest of the institution+ It further recommended that

when a nominee of an institution is appointed as a director of the compan", he should have

the same responsibilit", be subect to the same discipline and be accountable to the

shareholders in the same manner as an" other director of the compan"+ In addition, if the

nominee director reports on the affairs of the compan" to a department of the institution that

nominated him on the board of the portfolio compan", the institution should ensure that there

eist Chinese walls between such department and other departments which ma" be dealing in

the shares of the compan" in the stock market+

The .ara"an =urth" Committee felt that the institution of nominee directors whether from

investment institutions or lending institutions creates a conflict of interest+ The Committee

recommended that nominee directors should not be considered as independent and stressed

that it is necessar" that all directors, whether representing institutions or otherwise, should

have the same responsibilities and liabilities as other directors+

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>owever, as discussed in !ection ;, the final guidelines issued b" !&$I in Clause 4: suggest

that nominee directors whether from lending or investment institutions shall be deemed to be

independent directors+

R/1E /F IN#-I-.-I/N01 IN2E#-/R#

Corporate governance codes and guidelines have long recognised the important role that

institutional investors have to pla" in corporate governance+ The effectiveness and credibilit"

of the entire corporate governance s"stem and the compan" oversight to a large etent

depends on the institutional investors who are epected to make informed use of their

shareholders% rights and effectivel" eercise their ownership functions in companies in which

the" invest+ Increased monitoring of Indian listed corporations b" institutional investors will

drive the former to enhance their corporate governance practices, and ultimatel" their abilit"

to generate better financial results and growth for their investors+ 1t present, there are four

main issues with role of institutional investor and corporate governance/

Issues relating to disclosure b" institutional investors of their corporate governance

and voting policies and voting records

Issues relating to the disclosure of material conflicts of interests which ma" affect the

eercise of ke" ownership rights

ocus on increasing the si9e of assets under management rather than on improving

the performance of portfolio companies+

Institutional investors are becoming increasingl" short6term investors+

!everal countries mandate their institutional investors acting in a fiduciar" capacit" to

disclose their corporate governance policies to the market in considerable details+ !uch

disclosure reuirements include an eplanation of the circumstances in which the institution

will intervene in a portfolio compan"- how the" will intervene- and how the" will assess the

effectiveness of the strateg"+ In most &C' countries, Collective Investment !chemes )CI!*

are either reuired to disclose their actual voting record, or it is regarded as good practice and

implemented on an Dcompl" or eplainE basis+

In addition, (rinciple 7G of the &C' (rinciples calls for institutional investors acting in a

fiduciar" capacit" to disclose their overall corporate governance and voting policies with

2#| , a g e


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respect to their investments, including the procedures that the" have in place for deciding on

the use of their voting rights+

!&$I has recentl" reuired listed companies to disclose the voting patterns to the stock

echanges and 1sset =anagement Companies of =utual unds to disclose their voting

policies and their eercise of voting rights on their web6sites and in 1nnual Reports+ =inistr"

of Corporate 1ffairsQ )=C1* initiative on &6voting will also enable scattered minorit"

shareholders to eercise voting rights in General =eetings+

a) Institutional inestors s!ould !ae a clear policy on oting and disclosure o" oting

actiity

Institutional investors should seek to vote on all shares held+ The" should not automaticall"

support the board+ If the" have been unable to reach a satisfactor" outcome through active

dialogue then the" should register an abstention or vote against the resolution+ In both

instances, it is good practice to inform the compan" in advance of their intention and the

reasons thereof+ Institutional investors should disclose publicl" voting records and if the" do

not, the reasons thereof+

b) Institutional inestors to !ae a robust policy on managing con"licts o" interest

1n institutional investorQs dut" is to act in the interests of all clients and5or beneficiaries when

considering matters such as engagement and voting+ Conflicts of interest will inevitabl" arise

from time to time, which ma" include when voting on matters affecting a parent compan" or

client+ Institutional investors should formulate and regularl" review a polic" for managing

conflicts of interest+

c) Institutional inestors to monitor t!eir inestee companies

Investee companies should be monitored to determine when it is necessar" to enter into an

active dialogue with their boards+ This monitoring should be regular and the process should

be clearl" communicable and checked periodicall" for itseffectiveness+

1s part of these monitoring, institutional investors should/

!eek to satisf" themselves, to the etent possible, that the investee compan"Qs board

and committee structures are effective, and that independent directors provide

adeuate oversight, including b" meeting the chairman and, where appropriate, other

board members-

=aintain a clear audit trail, for eample, records of private meetings held with

companies, of votes cast, and of reasons for voting against the investee compan"Qs

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management, for abstaining, or for voting with management in a contentious

situation- and

1ttend the General =eetings of companies in which the" have a maor holding, where

appropriate and practicable+Institutional investors should consider carefull" the eplanations given for departure from the

Corporate Governance Code and make reasoned udgements in each case+ The" should give a

timel" eplanation to the compan", in writing where appropriate, and be prepared to enter a

dialogue if the" do not accept the compan"Qs position+

Institutional investors should endeavor to identif" problems at an earl" stage to minimise an"

loss of shareholder value+ If the" have concerns the" should seek to ensure that the

appropriate members of the investee compan"Qs board are made aware of them+

Institutional investors ma" not wish to be made insiders+ The" will epect investee companies

and their advisers to ensure that information that could affect their abilit" to deal in the shares

of the compan" concerned is not conve"ed to them without their agreement+

d) Institutional inestors to be #illing to act collectiely #it! ot!er inestors #!ere

appropriate

1t times collaboration with other investors ma" be the most effective manner to engage+

Collaborative engagement ma" be most appropriate during significant corporate or wider

economic stress, or when the risks posed threaten the abilit" of the compan" to continue+

Institutional investors should disclose their polic" collective engagement+ #hen participating

in collective engagement, institutional investors should have due regard to their policies on

conflicts of interest and insider information+

e) Institutional inestors to establis! clear guidelines on #!en and !o# t!ey #ill escalate

t!eir actiities as a met!od o" protecting and en!ancing s!are!older alue

Institutional investors should set out the circumstances when the" will activel" intervene and

regularl" assess the outcomes of doing so+ Intervention should be considered regardless of

whether an active or passive investment polic" is followed+

Initial discussions should take place on a confidential basis+ >owever, if boards do not

respond constructivel" when institutional investors intervene, then institutional investors will

consider whether to escalate their action, for eample, b" L holding additional meetings with

management specificall" to discuss concerns-

epressing concerns through the compan"Qs advisers-

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meeting with the chairman, senior independent director, or with all independent

directors-

intervening ointl" with other institutions on particular issues-

making a public statement in advance of the 1G=-

submitting resolutions at shareholdersQ meetings- etc+

") Institutional inestors to report periodically on t!eir responsibilities and oting

actiities

Those who act as agents should regularl" report to their client%s details of how the" have

discharged their responsibilities+ !uch reports ma" comprise of ualitative as well as

uantitative information+ The particular information reported, including the format in which

details of how votes have been cast are presented, should be a matter for agreement between

agents and their principals+

Those that act as principals, or represent the interests of the end6investor, should report at

least annuall" to those to whom the" are accountable on their polic" and its eecution+ owever, there is onl" a marginal increase in for5against votes and man" funds failto even attend meetings and have abstention as a polic"+ &ven among funds that voted, there

is little alignment between the votes and the voting polic"+

In view of above, eisting polic" need to be eamined+ It ma" be deliberated on how to create

incentives for institutional investors that invest in euities to become more active in the

eercise of their ownership rights, without coercion, without imposing illegitimate costs on

them, and given India%s specific situation+

und houses should be mandated to adopt the global practice of uarterl" vote reporting and

fund6wise vote reporting and to adopt detailed voting policies+ urther, vote reporting b" fund

houses should also be subect to audit+

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-!e role of institutional investors in ot!er countries:

!everal countries mandate their institutional investors acting in a fiduciar" capacit" to

disclose their corporate governance policies to the market in considerable details+ !uchdisclosure reuirements include an eplanation of the circumstances in which the institution

will intervene in a portfolio compan"- how the" will intervene- and how the" will assess the

effectiveness of the strateg"+ In most &C' countries, Collective

Investment !chemes )CI!* are either reuired to disclose their actual voting record, or it is

regarded as good practice and implemented on an Dappl" or eplainE basis+ Table 2 below

summari9es current practices in 1ustralia, rance, Ital", (ortugal, !weden, !wit9erland, the

3, and the 3!+

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37| , a g e

Country Current practice

$ustralia There is no obligation under applicable law for fund managers or trusteesto attend shareholders meetings or vote on resolutions+ >owever, theInvestment and inancial !ervices 1ssociation )I!1* recommends thatits members, as a matter of good practice, should OP vote on all materialissues at all 1ustralian compan" meetings where the" have the votingauthorit" and responsibilit" to do so- and have a written polic" on theeercise of pro" voting+, rance The rench association 1G61!Iconsiders it ver"

France The rench association 1G61!I considers it ver" important for assetmanagement portfolio companies to develop voting guidelines, includingvoting criteria on resolutions+ The 1G61!I also strongl" encouragesCI! operators to eercise voting rights and account for this eercise inCI! annual reports+

Italy The Italian 1sset management 1ssociation has issued guidelinesDreuiring asset management companies to formali9e and keep

appropriate records showing the decision6making process followed ineercising the voting and other rights attached to financial instrumentsunder management and the reasons for the decisions where the voteconcerns a compan" belonging to the same group as the !GR+ The

position adopted in a shareholders% meeting shall be reported, in relationto their importance, to investors in the CI! annual report or in some otherappropriate manner previousl" establishedE+

Portugal CI! must disclose to the C=;=, the regulator" agenc", and the market,how the CI! eercised its voting rights when the latter holds more than 2

percent of the voting rights of an issuer+ In addition, its annual report, themanagement compan" must identif" and ustif" an" deviation on the

voting polic", when it holds more than 7 percent of the voting rights ofan issuer+ 'isclosure is either to their clients )onl" with respect to thesecurities of each client* or, in the case of investment advisor, to theregistered investment companies, or to the market, which is less costl"+

S#eden The !wedish 1ssociation recommends that CI! operators OP establishand publici9e policies on corporate governance containing principles foreercising voting rights and for electing board members+ CI! operatorsshould also disclose to investors their standpoint in certain corporateissues and the reason for their position+ !wit9erland The !wiss und1ssociation )!1* emphasi9es

S#it%erland The !wiss und 1ssociation )!1* emphasi9es the obligation of CI!operators to eercise shareholders rights pertaining to the investments ofthe CI! independentl" and eclusivel" in the interest of investors+ CI!are reuired to be able to provide investors with information on theireercise of their rights+ 'elegation is permitted to custodian banks orother third parties, ecept where the eercise of the right could havelasting impact on the interest of the investors+ In such cases the CI!operator is to eercise the rights itself or give eplicit directions to itsdelegates+

U& The 3 1ssociation of 3nit Trusts and Investment unds )13TI*emphasi9es in its Code of good (ractice that fund managers should

become involved in governance matters and should report to theirinvestors on their polic" on voting and other governance issues+ 3! The!&C recentl" issued a ruling mandating CI! to disclose their

US The !&C recentl" issued a ruling mandating CI! to disclose their pro"voting policies and pro" voting records+ The ruling reuires registeredmanagement investment companies to file with the !&C and to makeavailable to shareholders the specific pro" votes that the" cast inshareholder meetings of issuers of portfolio securities+


35/47

!ource/ I!C

andate for Conflicts of interests in /EC" Countries'

Country Current Practices

$ustralia Hes, in the prospectuses, the annual report and (roduct 'isclosure!tatements+ In addition, when the operator of the CI! seeks to confer afinancial benefit on itself or a related part", it ma" onl" do so with the

prior approval of the scheme members+

$ustria .o+

elgium Hes, in the annual reports+Canada Hes, in the prospectus, the annual and semi6annual financial statements+

In certain circumstances, prior approval is reuired for investors inadvance of the transaction+

C%ec! epublic Hes, in the prospectus+

*enmar+ Hes, in the annual reports+ The prospectus must disclose information oncontracts with related parties, including the management compan"

Finland Hes, in semi6annual and annual reports+

France Hes, in the annual reports+

ermany Hes, in semi6annual and annual reports

reece .o+

-on+ &ong

C!ina

Hes, in the annual reports and offering documents+

-ungary .o+

Italy Hes, the directors% statements accompan"ing the CI! annual reports mustinclude a description of the dealings with other companies belonging tothe same group, and information on participation in placements carriedout b" companies within the group+

.apan Hes, in the financial statements

&orea Hes, the Trust (ropert" =anagement Report is provided to investorsever" si months+ The report includes the details of management of trust

propert", details on investment in securities issued b" an affiliatedcompan", and details on transactions made b" a management compan" orconnected part" with trust propert"+

/u0emburg .o

Me0ico Hes, in the prospectus+

Net!erlands Hes, in the prospectus, semi6annual and annual reports

Nor#ay Hes, in the prospectus, semi6annual and annual reports

Poland Hes, in the prospectus, semi6annual and annual reports

Portugal Hes+

Singapore Hes, in the prospectus, semi6annual and annual reports

Sloa+ia Hes, in the semi6annual and annual reports+

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&/1IC4 REC/EN"0-I/N#

1!e recommendations o" t!e &umaramangalam irla Committee on t!e issue o"

Institutional s!are!olders proide t!e "rame#or+ "or policy ma+ers interention in

India+ The Committee highlighted that institutional shareholders, who own shares largel" on

behalf of the retail investors, have acuired large stakes in the share capital of listed Indian

companies- the" have or are in the process of becoming maor shareholders in man" listed

companies and own+ The Committee called for institutional investors to pla" a bigger role in

the corporate governance of their portfolio companies, and stressed that retail investors are

rel"ing on them for positive use of their voting rights+ The Committee highlighted practices

elsewhere in the world where institutional shareholders influence the corporate policies of

their portfolio companies to maimi9e shareholder value, and recommended that institutional

investors follow suit+ The Committee stressed that it is important that institutional

shareholders should put to good use their voting power+

The Committee recommends that the institutional shareholders should take an active interest

in the composition of the board of directors of their portfolio companies- be vigilant- maintain

regular and s"stematic contact at senior level for echange of iews on management, strateg",

performance and the ualit" of management- ensure that voting intentions are translated into

practice- and evaluate the corporate governance performance of their portfolio companies+

These were non6mandator" recommendations+

Incenties "or institutional inestors to play a more actie role in t!e corporate

goernance o" t!eir port"olio companies' It has long been recogni9ed that institutional

36| , a g e


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investors, especiall" those acting in a fiduciar" capacit", are better positioned than retail

investors to pla" a monitoring role in their portfolio companies because the" do not face the

collective action )free rider* problem to the same etent )!ee $o67 for a description on free

rider and collective action*+ The potential returns from their euit" investment can outweigh

the monitoring costs+ >owever, as discussed in !ection I;, at present most Indian

institutional investors take a passive role in the corporate governance of their portfolio

companies+ &ven those institutions who eercise their ownership rights more activel", to a

large etent share the same view with regard to the monitoring of management+ =anagement

is primaril" screened ex-ante, at the time of deciding to take an euit" position in a compan"+

nce an institution has taken the decision to invest in a compan", it supports its management+

If and when it loses confidence in management, it sells its shares+

rom a cost5benefit standpoint, institutional investors consider that the potential benefits of

taking an active role in the corporate governance of their portfolio companies are not

commensurate with the costs associated with such monitoring role+ This approach ma" be

legitimate, given the concentrated ownership structure of listed companies, the small euit"

stakes of each individual institutional investor, and the lack of cooperation between

institutional investors+

>owever, the eperience of &C' countries and the most d"namic emerging market

Countries suggests that corporate governance practices of listed companies and their

voluntar" compliance with Clause 4:, and ultimatel" the protection of shareholders rights,

could be improved if institutional investors acting in a fiduciar" capacit" could be induced to

participate more activel" in the corporate governance of their portfolio companies+ rom a

polic" standpoint, it is desirable that institutions acting in a fiduciar" capacit", such as

pension funds, collective investment schemes and insurance companies should consider the

right to vote an intrinsic part of the value of the investment being undertaken on behalf of

their client+ ailure to eercise the ownership rights could result in a loss to their investors

who should therefore be made aware of the polic" followed b" the institutional investors+

In the 3nited !ates, under the &mplo"ee Retirement Income !ecurit" 1ct )&RI!1*, a pension

plan fiduciar" obligation includes the voting of proies+ In addition, the 'epartment of


38/47

urged to develop written voting guidelines+ The 'epartment of


39/47

rights, without coercion, without imposing illegitimate costs on them, and given India%s

specific situationS

Policy ecommendation 2 3' ased on discussions #it! policy ma+ers, mar+et

regulators and mar+et participants, and ta+ing into account t!e current topology o"

Indias institutional inestment community, a least cost, oluntary approac! to

compliance #it! 45C* Principle 36 seems most appropriate "or India, at least "or t!e

ne0t "e# years6 Suc! an approac! #ould introduce 7so"t8 incenties "or institutional

inestors to di""erentiate t!emseles "rom eac! ot!er and leae mar+et "orces to drie

t!e process6 It is t!ere"ore recommended t!at t!e Securities and 50c!ange oard o"

India "or mutual "unds and FIIs, and t!e Insurance egulatory and *eelopment

$ut!ority "or insurance companies, and t!e Pension Fund egulatory and *eelopment

$ut!ority "or pension "unds )when these are set up* issue some guidelines, on a

standalone basis or as part o" t!eir code o" conduct as appropriate, recommending t!at

t!e institutions t!at "all under t!eir oersig!t, s!ould disclose to t!e mar+et, on a

comply or e0plain basis, ia t!eir company #ebsite, t!eir oerall corporate goernance

and oting policies #it! respect to t!eir inestments, including t!e procedures t!at t!ey

!ae in place "or deciding on t!e use o" t!eir oting rig!ts6 It s!ould also be

recommended t!at t!ese institutions post annually on t!e same #ebsite, t!eir oting

records, on an e09post basis6

or deciding on the use of its voting rights to avoid window dressing+ Indeed, unless an

institution has made the necessar" investments in terms of financial and human resources to

implement its corporate governance and voting policies in an informed manner, such policies

would become empt" words+ ne of the advantages of this approach is that it sets the

framework for institutional investors to start cooperating more activel" with each other+

Indeed, an institutional investor inclined to vote against management on a specific issue could

more easil" contact those institutional investors who have epressed the same prima facie

concerns on this t"pe of issue, publicl"+ !uch discussions would allow the institutional

investor to establish with greater certaint" the likelihood that his vote would be DpivotalE,

with the support of those institutional investors with whom he has spoken+ n this basis, he

might be encouraged to cast his vote+

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ver the medium term, as the market starts pa"ing attention to the manner in which

institutional investors eercise their voting rights, new incentives could be introduced so that

institutional investors start disclosing their voting intentions ahead of shareholders meetings,

i+e+ on e6ante basis+ This practice could in time, foster the emergence in the market place, of

an independent private organi9ation )perhaps an offshoot of the financial anal"st industr"*,

that would aggregate voting records information for the benefit of all investors, including

retail investors, who could then align their votes with those of institutional investors, without

having to perform costl" sophisticated anal"sis themselves, rather than abstaining or

s"stematicall" supporting incumbent management+

This might also introduce more efficienc" in the market for corporate control, as an added

disciplinar" mechanism+ In addition, the disclosure of voting records b" institutional

investors acting in a fiduciar" capacit" could foster the emergence of one or several private

watchdog institutions, similar to Institutional !hareholder !ervices Inc, a 3! based compan",

or (IRC in the 3, that issue informed research and obective vote recommendations on

listed companies+

Con"licts o" interest/ ver the last decade and a half, market forces have driven Indian

financial services companies to seek critical mass+


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$nd 50c!ange oard o" India "or Mutual Funds and t!e Insurance egulatory and

*eelopment $ut!ority "or Insurance Companies s!ould mandate t!e disclosure by

institutions under t!eir oersig!ts o" !o# t!ey manage material con"licts o" interests

t!at may a""ect t!e e0ercise o" +ey o#ners!ip rig!ts regarding t!eir inestments6 More

generally suc! disclosure s!ould e0tend to all institutional inestors acting in a "iduciary

capacity6 1!e disclosure s!ould be made in t!e prospectuses and in t!e periodic

"inancial statements6 Facilitating t!e e0ercise o" s!are!olders rig!ts'

To support the previous recommendation, it is essential that polic" makers ensure that the

eercise of ownership rights b" shareholders is facilitated+ ;oting should be made as eas" as

possible to encourage institutional investors to eercise their voting rights+ The following

deficiencies have been identified in this respect/

)7* The 2004 CG R!C assessment mentioned that some companies have taken advantage of

1rticle of the Companies 1ct, which stipulates that shareholders meetings must be convened

at the location where the compan" is registered, to deter shareholders from attending

shareholders meetings+ These companies register their administrative headuarters in remote

locations, and choose the most inconvenient dates and times for their shareholders meetings,

to dissuade shareholders from attending the meetings+ 1ccording to interviewees, this

conspiratorial practice continues to occur+

)2* ver the last ten "ears, electronic communication has profoundl" transformed the means

through which shareholders can cast their votes+ =ost &C' governments have recogni9ed

this and have introduced legislation to enable electronic voting+ In the words of epon"mous

=r+ (aul ="ners, Delectronic voting lies at the heart of a more efficient voting s"stemE+

International good practice consists of allowing the electronic appointment of proies instead

of organi9ing electronic polls+ This practice does not eist in India at present+

)8* In addition, the 2004 CG R!C assessment mentioned that holders of depositor" receipts

do not have the same rights and opportunities to vote as holders of underl"ing shares+ inall",

a complementar" approach to participating at shareholders meetings is to engage in a

continuous dialogue, on a one to one basis, with the management of portfolio companies+

This approach allows investors to increase their level of comfort with management and to

better understand the contet in which the compan" operates+ It also routinel" in the most

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developed securities markets+ In some &C' countries there are also principles calling for

the nomination of a contact person on the board who retains close contact with such investors

and form an intermediar" between the institutions and the management+

The &C' (rinciples emphasi9e that such Da dialogue between institutional investors and

companies should be encouragedE and stress that unnecessar" regulator" barriers should be

lifted, notwithstanding the need for issuers to treat all shareholders euall" and not to divulge

information to the institutional investors which is not in the public domain+

1s discussed in section I;, Indian institutional investors seldom convene such meetings

although most of them do attend anal"sts meetings+ >owever, when uestioned about a

h"pothetical disagreement with management, all respondents answered that the" would

endeavour to epress their views to the former privatel"+ If a satisfactor" compromise could

not be reached in private, the" would prefer to sell their shares rather than making their views

public+ 1s Indian institutional investors start eercising their ownership rights more activel",

it is to be epected that such meetings will occur more freuentl"+

Policy recommendation 2 :'

(3) Consider including a proision in t!e Companies $ct currently under to reie# to

preent companies to conene s!are!olders meeting in "ar a#ay locations6

(;) Policy ma+ers s!ould reie# t!e In"ormation $ct ;>; and its ;


43/47

s!ould stress t!at it does not condone t!e selectie disclosure o" in"ormation by

companies to institutions and clearly set t!e principle o" e?uality o" treatment o" all

s!are!olders by corporations6 Facilitating cooperation bet#een institutional inestors

#!ile sa"eguarding mar+et integrity'

Institutional investors do not face the collective action )free rider* problem to the same etent

as retail investors because the" have the capacit" to make larger investments+ .evertheless,

the free rider problem can never be eliminated completel"+ If an institution invests resources

in monitoring activities, others will gain without having contributed+ ne wa" around this

problem is for institutions, particularl" those acting in a fiduciar" capacit", to increase their

ownership stakes in individual companies to more economic levels, rather than simpl"

diversif"+ The potential returns from their euit" investment can then outweigh the

monitoring costs+ >owever, in man" countries, including India, the" are prevented from

doing this for prudential reasons+

In addition, it ma" be difficult for institutions that are unhapp" with the corporate governance

of a compan" simpl" to sell their investment+ $ecause of the si9e of their shareholdings, it

ma" be not be possible to sell the holding uickl" and also obtain a reasonable price+ r the

shares ma" be trading below the compan"%s asset backing )possibl" due to the ver" conduct

about which the institution is unhapp"* and this ma" mean that selling is not an attractive

option+ The abilit" of inde funds to sell ma" be limited b" the etent to which the" can

depart from the inde

+

ne solution around this problem is to allow and even facilitate shareholders to cooperate in

eercising a strong monitoring role in a target compan"+ This approach allows institutions to

increase their leverage over management without having to acuire more shares+ The practice

has become uite common in 1ustralia, the 3! and the 3 in particular+ !uch practice is to

be encouraged since it provides a means of overcoming the free rider problem+ 1s discussed

in section I;, Indian institutional investors currentl" almost never consult with each other on

matters of corporate governance of their portfolio companies+

The danger, however, is that such cooperation could be used to manipulate markets and to

obtain control of a compan" without being subect to takeover regulations+ To prevent such

occurrence !&$I, like other market regulators around the world, has issued a series of

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takeover rules and market manipulations guidelines?+


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Nominee directors appointed b" an" institution or in pursuance of an" agreement or

Government appointees representing Government shareholding should not be deemed to be

independent directors+

/iabilities o" independent and non9e0ecutie directors6 1 noneecutive5 independent

director should be held liable onl" in respect of a violation of the law which had taken place

with his knowledge )attributable through $oard processes* and where he has not acted

diligentl", or with his consent or connivance+

&no#ledge 1est6 If the independent director does not initiate an" action upon knowledge of

an" wrong, such director should be held liable+ nowledge should flow from the processes of

the $oard+ 1dditionall", upon knowledge of an" wrong, follow up action5dissent of such

independent directors from the commission of the wrong should be recorded in the minutes of

the board meeting+

Policy recommendation 2 @' It is di""icult to reconcile !o# nominee directors o"

"inancial institutions, #!ic! are serice proiders to a company or !old signi"icant

e?uity sta+es, can be considered 7independent8, according to t!e de"inition o" Clause

=>6 It is t!ere"ore recommended t!at t!e e0planation to t!e de"inition o" independent

directors o" Clause => s!ould be amended to recti"y t!is point6 /ending Institutions may

legitimately #is! to continue to negotiate t!e appointment board members on t!e

boards o" companies in #!ic! t!ey !old a signi"icant e?uity sta+e or !ae lent

signi"icant sums o" money6 ut suc! directors s!ould not be counted as independent6

Suc! clari"ication #ould create an incentie "or lending institutions to ta+e an actie

part in t!e nomination o" ?uali"ied independent directors, capable o" protecting t!eir

rig!ts6

1!e internal corporate goernance of institutional inestors' inall", as highlighted at the

beginning of this polic" paper, the #orld $ank%s terms of reference for this stud" did not

include a review of the corporate governance of institutional investors themselves+

.evertheless, it impossible to consider the role of institutional investors in the corporate

governance of their portfolio companies without being confronted to several features of their

own internal corporate governance+ rom the limited amount of information gathered during

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this eercise, it appears that Chinese walls between lending and investing activities of the

same financial institution are not alwa"s strictl" enforced, and that several t"pes of related

part" transactions, such as the sales and purchases of funds units from insiders and affiliated

entities, or dealings with affiliated entities such as brokers, ma" not be adeuatel" covered b"

the eisting legislation or enforced b" regulator" agencies+ #ithout detailed anal"sis, it is

impossible opine on whether the risk management s"stems of mutual funds and insurance

companies, including their supervisor" structures, internal controls, and the procedures for

approving new investment strategies and instruments, and the standards of financial

reporting, compl" with international best practice+

urthermore, polic" makers are currentl" preparing the legislation that will permit the

Introduction of private pension funds in the institutional landscape+ It is reasonable to

&pect that the integrit" and efficienc" of the Indian capital market improves markedl" over

the net few "ears+ It will then become desirable to allow public and private pension funds to

invest in domestic euities+ Therefore, over the medium term, it is likel" that these

institutions will become maor investors in the domestic capital market, including the euit"

market+ It therefore is important that corporate governance considerations be included in their

investment guidelines and code of conduct+

Policy recommendation 2A' t!e corporate goernance o" institutional inestors

acting in a "iduciary capacity s!ould be a !ig! priority "or t!e 4I+

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References:

7+ $anai, Fairus and Gautam =od"+ DCorporate Governance and the Indian (rivate !ector,E

&> #orking (aper !eries6&>#(!8, =a" 2007+

2+ .achane, ' =, !aibal Ghosh and (artha Ra"+ D$ank .ominee 'irectors and Corporate

(erformance/ =icro6&vidence for India,EEconomic and Political Weekly, =arch 7:, 200?+

8+ (atibandla, =urali+ D&uit" (attern, Corporate Governance and (erformance/ 1 !tud" of

India%s Corporate !ector,E orthcoming,Journal of Economic Behavior and Organization

4+ !arkar, !ubrata and Fa"ati !arkar+ D

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Corporate Governance and the Role of Institutional Investors

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