1

LEGAL ASPECTS OF BUSINESS

SHAREHOLDER ACTIVISM IN INDIA -

SHORT OF ACTION

Subramaniam S

2013PGPM054

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EXECUTIVE SUMMARY

The recent spate of crises afflicting the corporate and financial sectors

around the world has triggered a new wave of corporate governance

reforms, which call for greater empowerment of institutional and retail

shareholders. The need for such reforms cannot be greater than in

India where controlling shareholders, or promoters, dominate the

corporate landscape.

Consistent with reforms in several countries that seek to confer greater

power in the hands of shareholders, the recent regulatory

developments in India signify a greater opportunity for shareholder

participation in the form of postal ballot, e-voting and the like. The

rapid proliferation of proxy advisory firms, a hitherto non- existent

phenomenon in India, bestows shareholders with the advice

necessary to exercise their corporate franchise in an informed manner.

The presence of activist institutional shareholders such as private

equity funds and hedge funds has already caused an upheaval in some

corporate boardrooms in India.

While these developments pave the way for a transformation in the

tenor of the governance debate, shareholder activism encounters

certain structural and institutional weaknesses embedded in the Indian

markets. The dominance of controlling shareholders in most Indian

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companies operates to dampen the effects of shareholder activism.

The legal system and institutions in India are not conducive to

rendering timely and cost-effective remedies to shareholders who

adopt a litigation strategy to counter managements that are perceived

to act inimical to shareholder interests. This report finds that although

shareholder activism is becoming palpable in the Indian markets, its

impact as a measure of corporate governance enhancement is far from

clear.

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Contents

1. Introduction ................................................................................... 1

2. Shareholder Activism: The Concept .............................................. 3

A. Collective Action Problems ........................................................ 3

B. Defining the Concept ................................................................. 5

3. Shareholder Passivity as the Starting Point ................................... 7

4. Regulatory Reforms Towards Greater Shareholder Participation .. ..................................................................................................... 11

A. Voting Methods ....................................................................... 11

B. Shareholder Meetings .............................................................. 13

C. Voting as Responsibility ........................................................... 15

D. Assessing the Reforms ............................................................. 16

5. Corporate Governance Intermediaries ........................................ 18

A. Proxy Advisors in India: Their Influence................................... 19

B. Concerns and Possible Mitigating Factors ............................... 21

C. Other Informational Intermediaries ........................................ 25

6. Feasibility of Interactive/Combative Strategies .......................... 26

A. Interactive Strategy .................................................................. 27

B. Change of Control Strategy ...................................................... 29

C. Litigation Strategy .................................................................... 30

7. Evaluating the Impact of Shareholder Activism .......................... 32

A. Distilling the Evidence .............................................................. 32

B. Effect on Controlled Companies .............................................. 35

8. Conclusion .................................................................................... 38

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1. Introduction

The last two decades have witnessed a significant thrust towards

enhanced corporate governance standards in India. While some of

this may be attributable to the globalization of governance practices

that have had their impact on Indian companies, regulatory reforms

spearheaded by the Securities and Exchange Board of India (SEBI) have

also had a role to play. Since 2000, SEBI has required public listed

companies to deploy well-recognized governance structures and

mechanisms. These include an independent board of directors, an

independent audit process, certification of financial statements by the

chief executive officer and chief financial officer, and the like. These

efforts have been embraced by the stock markets that have conferred

a premium towards good governance practices.

At the same time, the existing standards are said to be far from the

desirable, and governance crises such as that witnessed in the

Satyam accounting scandal have underscored this line of criticism.

Given the influence of controlling shareholders in most Indian

companies, one of the significant shortcomings in the current

dispensation is the lack of shareholder activism, particularly amongst

institutional and retail investors that hold minority stakes. This

perceived weakness in Indian corporate governance appears to be

addressing itself through the onset of activist shareholders in the

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Indian corporate sphere, whose efforts have been further buoyed by

regulatory reforms. The phenomenon of shareholder activism, hitherto

absent in India, has made its mark rapidly, and has become a force to

reckon with for Indian listed companies.

Consistent with reforms in several countries that seek to confer greater

power in the hands of shareholders, the recent regulatory

developments in India signify a greater opportunity for shareholder

participation in the form of postal ballot, e-voting and the like. The

rapid proliferation of proxy advisory firms, a hitherto non-existent

phenomenon in India, bestows shareholders with the advice necessary

to exercise their corporate franchise in an informed manner. The

presence of activist institutional shareholders such as private equity

funds and hedge funds has already caused an upheaval in some

corporate boardrooms in India.

While these developments pave the way for a transformation in the

tenor of the governance debate, shareholder activism encounters

certain structural and institutional weaknesses within the Indian

markets. The dominance of controlling shareholders in most Indian

companies operates to dampen the effects of shareholder activism.

The legal system and institutions in India are not conducive to

rendering timely and cost-effective remedies to shareholders who

adopt a litigation strategy to counter managements that are perceived

3

to act inimical to shareholder interests. This report finds that although

shareholder activism is becoming palpable in the Indian markets, its

impact as a measure of corporate governance enhancement is far from

clear.

2. Shareholder Activism: The Concept

Before examining definitions of shareholder activism, it would be

useful to identify the problem that the concept seeks to address.

A. Collective Action Problems

In large public listed companies, the public (or non-promoter)

shareholders have relatively small stakes and these do not provide

sufficient incentives for them to act together and form coalitions to

meaningfully participate in decision-making of companies. In the classic

Berle & Means corporation where shareholding is diffused, while the

shareholders are owners of the company, the managers controlling

the company as shareholders are unable to participate in decision-

making due to collective action problems. Even in controlled

companies, which are predominant in India, collective action

problems prevent minority shareholders from coalescing, which

reduces their effective participation through the exercise of corporate

franchise. In such a case, the lack of minority shareholder participation

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augurs to the benefit of the controlling shareholders, and managers

appointed with their concurrence. Related to the collective action

problem is shareholder apathy. Since the costs of coordination

among minority shareholders are high, these shareholders either

abstain from voting or merely vote in favor of management (or the

controlling shareholders, as the case may be).

Due to collective action problems and shareholder apathy, both retail

and institutional investors have historically been passive shareholders.

The evolution of more active shareholders has been fairly recent.

It is only in the 1980s that even developed economies such as the

United States (US) witnessed the phenomenon of active investors,

which began through institutional investors such as pension funds and

other large institutional investors. Unsurprisingly, this field

has attracted academic research only more recently, as compared to

other areas of corporate governance.

With this background, it would be useful to examine how shareholder

activism may be defined, and also to consider various types of

activism.

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B. Defining the Concept

Shareholder activism is considered to be a set of proactive efforts [on

the part of shareholders] to change firm behavior or governance

rules. It signifies the efforts on the part of investors to influence the

behavior of management in governing the company. Activist investors

are often viewed as investors who, dissatisfied with some aspect of a

companys management or operations, try to bring about change

within the company without a change in control.

Activist investors can be contrasted from passive investors, who rarely

participate in corporate decision-making. Passive investors usually

vote with their feet. If they are not satisfied with decisions taken by the

management or controlling shareholders, they simply exit the company

by selling their shares, a practice fancifully referred to as the Wall

Street walk.

There are various shades of shareholder activism, although this report

primarily deals with three. I refer to the first type as participative

shareholder activism. In this type, shareholders assume greater

responsibility for participating in shareholder meetings and

exercising their corporate franchise. This way, greater participation by

minority shareholders could have an impact on the outcome of

corporate decisions. Even if the decisions themselves may not be

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different because minority shareholders may only have infinitesimal

shareholding in the company, their overwhelming response cannot be

ignored altogether by managements and controlling shareholders.

While shareholders, particularly of the institutional variety, are

demonstrating greater interest in participative activism, legal reforms

in various jurisdictions are utilizing soft law and self-regulatory

mechanisms to encourage greater participation by shareholders in

corporate decision-making.

The second type of activism is more upfront. Interactive

shareholder activism involves the direct engagement by the

shareholders with the management. Large institutional shareholders

seek to interact with the management and obtain an assessment of

the affairs of the company. Such interaction usually takes place

when either the shareholders are unconvinced of the direction adopted

by the management on certain matters, or when the company

undertakes a major transaction (such as a merger) or suffers a

material adverse effect (such as a significant loss, or other

extraordinary event such as a corporate fraud). Shareholders not

only interact to obtain more information from the management,

but also to convince the management of the strategy to be followed

and changes to be effected to enhance value to shareholders. The

downside of the interactive type of activism is that management and

controlling shareholders are under no legal compulsion to engage

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with shareholders, and can simply choose to ignore them. In such a

case, the interactive efforts may not be fruitful.

An extended version of such interactive type brings us to the third

category where shareholders adopt a combative strategy. This involves

efforts to overthrow incumbent management through processes

such as proxy fights or hostile takeovers that result in a change in

control of the company. A more aggressive form involves the initiation

of litigation against the company, its board and management. Certain

types of investors, such as pension funds and hedge funds, have

utilized this strategy more recently in certain jurisdictions like the US to

achieve their goals.

With this background regarding the rationale for, and types of,

shareholder activism, the report now turns to the evolution of

the phenomenon in India.

3. Shareholder Passivity as the Starting Point

During the initial years since Indias independence, shareholder

passivity was all-pervasive. The equity markets were considerably

shallow, and retail investment in Indian listed companies was

negligible. Although a few leading Indian business houses had listed

companies within their stables, retail investors were unable to make

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any dent in the influence of controlling shareholders, who wielded

significant control over their companies due to the substantial

shareholding they commanded. Even if retail shareholders were able to

participate in shareholder meetings and express their views,

managements and controlling shareholders could afford to ignore the

minority voice due to their negligible shareholding in the company and

their consequent inability to affect the outcome of corporate decisions.

The legal regime governing corporate decision-making did not come

to the aid of retail shareholders either. Company meetings had to be

convened at specified physical locations. Several leading companies

had their registered offices in remote locations, which made retail

participation impossible, if not cumbersome. All of these resulted in

passivity among retail shareholders.

On the other hand, certain institutional shareholders such as banks,

development financial institutions (DFIs) and the then largest mutual

fund, the Unit Trust of India (UTI), held larger stakes in companies

in comparison to retail shareholders. It is reasonable to expect these

institutions to exercise their investment oversight more actively.

However, that was not necessarily the case. The banks, DFIs

and UTI were heavily subjected to governmental and bureaucratic

control and influence. Although these institutional shareholders often

appointed their nominees to the boards of investee companies and

also exercised their voting rights somewhat regularly, they were never

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perceived as independent investors or as a threat to management and

controlling shareholders. The strong nexus that existed between

government and industry ensured that the management always

enjoyed the support of these institutional shareholders. Hence,

although the institutions exercised greater level of participation than

retail shareholders, their influence as activists was minimal at best.

These influences continued to a large extent post-liberalization in

1991, but the shareholding of such government-controlled banks and

institutions in Indian companies has witnessed a dramatic fall in

recent years, due to which their influence has considerably waned.

A related category of institutional shareholders is foreign portfolio

investors. They invest into Indian listed companies through multiple

routes. Prominent among them is the foreign institutional investor

(FII) route, whereby FIIs may acquire and divest shares in Indian

companies through the stock exchange. All administrative aspects of

the investments are handled through domestic custodians appointed

for the purpose. Although FIIs hold substantial shares in

Indian companies, they have seldom exercised voting rights in those

companies, barring exceptional circumstances.

Another category of foreign investors subscribes to depository receipts

(DRs) in Indian companies instead of acquiring the underlying shares.

Interestingly, investors in DRs have not displayed any keenness at all

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in the exercise of voting rights on the underlying shares. As a

matter of law, since it is the depository that holds the underlying

shares, only it can exercise voting rights, and the DR holders do

not have any legal right to vote. A number of different models were

adopted through market practice to address this. In some cases,

voting rights have been conferred on the depository, to be exercised

according to the instructions of the board of directors of the company.

In such a case, the votes of the DR holders shares will be aggregated

with that of the management (and indeed, the controlling

shareholders). In other cases, custodians must exercise voting rights on

the DRs only when that is legally required. Since Indian corporate law

does not obligate shareholders to exercise voting rights, it is not

possible to envisage a situation when voting rights will ever be

exercised on such shares. Only in limited instances are depositories

required to exercise voting rights according to the wishes of the DR

holders. All of these suggest that in case of companies with DRs, the

votes in respect of the DRs are either exercisable in accordance with

the wishes of management, or the DRs have been effectively

disenfranchised. Managements and controlling shareholders therefore

faced virtually no influence from foreign institutional investors, who

either invested directly or through DRs.

Shareholder passivity, both among retail and institutional shareholders,

was the norm following liberalization as well, and continued to be so

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until very recently. However, this status quo seems to have been

disturbed more lately in the phase after the Satyam accounting

scandal. Not only have the regulators begun to recognize the need

for greater shareholder participation in Indian listed companies, but

investors themselves (particularly financial institutions) have sought

to monitor their investments more carefully. The report now turns to

these developments and their impact on corporate governance in India.

4. Regulatory Reforms Towards Greater Shareholder

Participation

Over the last decade, regulatory efforts in India have focused on

inducing greater participation in shareholder decision-making. This has

been implemented through a step-by-step approach that addresses

different facets of shareholder participation. These include the manner

of voting, the manner of participating in shareholders meetings, and

whether shareholders might be compelled to cast their votes. Each of

these is addressed below.

A. Voting Methods

In 2001, the facility of voting by postal ballot was introduced.

This was intended to address the problems faced primarily by retail

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shareholders who had to attend and physically participate in

shareholder meetings, often in remote locations of the country. The

system of postal ballot permits shareholders to send in their votes by

post instead of personally attending and voting at a meeting. A set of

rules promulgated by the Central Government listed certain resolutions

that are to be mandatorily put to vote by postal ballot. In other cases,

the company has the option to offer the postal ballot facility.

While the postal ballot facility represented a sea change in terms

of providing a better option for retail shareholders to cast their

corporate franchise, it failed to make a serious impact. The postal

ballot facility may have removed some of the procedural obstacles to

shareholder voting, but it was not intended to address the

broader issues of collective action problems and shareholder apathy.

Moreover, since shareholders are unable to participate in the

discussions, and to obtain the benefit of the deliberations in the

meeting before they cast their votes, participation levels have been

found to be extremely low. One report states that the response of

shareholders through postal ballot has been abysmally low at only

about 3% on average.

Given the inadequate functioning of the postal ballot system, more

recent regulatory developments have sought to utilize technological

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advancements to enhance shareholder participation and voting. On

this occasion, the initiative emanated from SEBI. In July

2012, SEBI amended the listing agreement requiring large companies

to provide electronic voting (e-voting) facilities in respect of matters

requiring postal ballot. According to this new dispensation, the top

500 listed companies on the Bombay Stock Exchange and the National

Stock Exchange are required to provide e-voting facility with effect

from October 1, 2012. Two agencies have already been certified to

provide e-voting platforms. Although it is too early to gauge the

effectiveness of e-voting, it is expected to generate greater

participation by shareholders. For example, the e-voting process is less

costly compared to the postal ballot, and involves less time and effort

on the part of the shareholders as well as the company. However, due

to its reliance on technology, the success of e-voting would depend on

the extent of penetration of computers and the Internet across

the country.

B. Shareholder Meetings

In order to enable the shareholders to exercise their corporate

franchise in an informed manner, it is important that they are able to

participate in meetings, both to make an assessment as to the

manner in which they should exercise their votes, also to speak at the

meetings and convey their views to enable the other shareholders

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to exercise their votes in an informed manner as well. Recognizing the

limitations of physical shareholders meetings, the Government of

India has introduced the concept of electronic participation.

Companies may now provide the option to shareholders to attend

meetings electronically, through audio-visual means, such that all

persons participating in that meeting communicate concurrently with

each other without an intermediary, and participate effectively in the

meeting. Moreover, companies may provide video conferencing

connectivity during such meetings in at least five locations within

India. At the same time, responsibility is placed on the company and

the chairman of the meeting to put in adequate safeguards to ensure

the integrity of the meeting. Although these measures were initially

intended to be mandatory for listed companies in the period

subsequent to the financial year 2011-12, concerns were raised

regarding the legal validity of electronic meetings in the context of the

Companies Act, due to which such electronic meetings are intended to

be optional for listed companies too.

Since these measures are only optional, and are yet to be fully

effective, they are unlikely to be widely followed. While it is certainly

possible that some of the blue-chip companies will adopt these

voluntary measures, widespread compliance across corporate India

may have to wait.

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C. Voting as Responsibility

Shareholding in a company is considered to be a bundle of rights. One

such right conferred is to participate in corporate decision-making

through the exercise of voting power. In this jurisprudential backdrop,

any kind of obligation or responsibility to exercise voting rights is

antithetical to the rights or entitlement-based understanding of share

ownership. Hence, shareholders cannot generally be compelled to

exercise their voting rights in any manner, or at all. This legal

understanding of share ownership does not facilitate greater

shareholder participation in companies, the consequence of which is

shareholder passivity.

Although shareholders cannot be compelled to exercise their votes,

regulatory authorities have begun to adopt market-based approaches

to address passivity among institutional investors. In a move that is

somewhat unconventional in the Indian context, SEBI has sought to

exhort a specific type of institutional investor, i.e. mutual funds, to

exercise their voting rights in investee companies in a responsible

manner. In 2010, SEBI issued a circular to mutual funds requiring them

to play an active role in ensuring better corporate governance of

listed companies. Adopting a comply-or-explain approach, SEBI

requires asset management companies of mutual funds to disclose

on their websites and in annual reports their general policies and

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procedures regarding the exercise of votes on listed companies.

Moreover, they are also required to disclose the specific exercise of

voting rights in respect of identified matters such as corporate

governance, changes to capital structure, mergers, takeovers, and the

like.

By imposing mandatory disclosure obligations and thereby enhancing

transparency, this compels mutual funds to take a more active and

considered role while exercising their voting rights on companies. It

may no longer be possible for mutual funds to either abstain from

voting or to grant proxies in favor of managements or controlling

shareholders without following a reasoned decision- making

process. This is particularly relevant because institutional investors

such as mutual funds possess significant shareholding (at least in

the aggregate, if not individually) with the power to tip the scales on

key voting matters such as mergers, change of control transactions,

preferential allotments of securities and the like.

While SEBIs circular technically applies only to mutual funds, its

broader message could well pave the way for greater participation by

other types of institutional shareholders.

D. Assessing the Reforms

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The regulatory reforms discussed in this section have been

fragmented in nature, but their common theme has been to increase

shareholder participation in meetings and voting. This would

strengthen the hands of minority shareholders, both of the retail and

institutional varieties, by removing various procedural hurdles that

have impeded their extensive participation in the past. By imposing

stewardship responsibilities on institutional investors such as mutual

funds, SEBIs goal has become clearer.

At the same time, it would be imprudent to assume that such

regulatory reforms would by themselves instill greater shareholder

participation. More specifically, institutional shareholder activism

must be self-generated, although a trend in India towards such

activism appears to be developing steadily.

Despite these regulatory reforms, one significant area of concern

continues to be the lack of adequate information available with

shareholders in order to enable them to exercise their considered

vote. While the Companies Act does contain elaborate provisions as to

the notice to be given to shareholders to convene meetings, both in

terms of the time period and information to be provided, the

disclosure and transparency standards followed in practice continue to

be below par. While there has been a gradual increase in the amount

and quality of information disseminated to shareholders to elicit their

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franchise, it is arguably inadequate. The lack of availability of quality

information strikes at the heart of shareholder indifference in the

exercise of voting rights. Intermediaries such as proxy advisors and

governance analysts can bridge the informational disparity to some

extent. While such intermediaries played a negligible role, if at all, in

Indian corporate governance in the past, they have revolutionized the

governance sphere in the last two years. In the next Part, I consider the

impact of these intermediaries on shareholder activism in India.

5. Corporate Governance Intermediaries

Globally, governance intermediaries such as proxy advisors play a

significant role in influencing corporate decision-making. Proxy

advisory firms analyze corporate proposals and make

recommendations to their clients, who are primarily institutional

investors, on the manner in which they should exercise their votes.

The firms also put out public recommendations, which can be utilized

by retail shareholders for whom it is uneconomical to specifically turn

to proxy advisors. The proxy advisory industry is rather well

established internationally, and it is actively involved in corporate

governance in jurisdictions such as the US. For example, the industry

leader, Institutional Shareholder Services (ISS) controls about 61% of

the market, and is a force to reckon with, as its recommendations are

capable of swinging the votes at shareholders meetings and altering

the outcome of the decision taken.

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A. Proxy Advisors in India: Their Influence

Since 2010, the proxy advisory industry has blossomed in India as well.

Within a span of two years, three proxy advisory firms have been

established in India, and they have already published hundreds of

recommendations regarding corporate proposals pertaining to

various listed companies in India. Their recommendations cover

companies proposals relating to the appointment of directors

(especially independent directors), the appointment of auditors,

and major corporate transactions such as mergers and takeovers.

Where there are governance concerns, the recommendations of proxy

advisors have been against the management proposals. For example,

these firms have recommended against appointment of independent

directors who have served companies for a long period of time,

although there is yet no maximum tenure mandatorily prescribed for

independent directors. They have raised similar concerns with respect

to auditor appointments. They have also registered opposition in the

case of mergers and corporate restructurings where there is a

likelihood value to the public shareholders might be eroded.

No longer can managements and controlling shareholders ignore

the influence of minority shareholders (both institutional and retail).

The recommendations of the proxy advisory firms have the effect of

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shedding greater light on corporate proposals, and of galvanizing

minority shareholders to overcome collective action problems and

shareholder apathy and to participate more effectively in corporate

decision-making. The fledgling nature of the proxy advisory industry in

India and the absence of systematic empirical evidence might not yet

indicate whether there has been greater exercise of minority franchise

in Indian listed companies, but the fact that the recommendations are

discussed in the public domain in a transparent manner (such as

through the financial press) is expected to operate as a set of checks

and balances against managements and controlling shareholders from

initiating proposals that might not pass muster from a governance

standpoint.

Another positive effect of the proxy advisory industry is its ability to

constantly enhance governance standards. Although listed companies

in India are required to comply with the standards of corporate

governance set out by law, the close monitoring by proxy advisory

firms will motivate companies to elevate their standards of

governance. It is expected that the industry will also help instill global

best standards and practices among Indian companies.

Proxy advisory firms also benefit institutional investors in other

ways. For example, it is no longer necessary for institutional

investors to spend efforts and costs on research, as they can simply

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outsource these functions to external firms. The investors and their

managements can train their resources on investment analysis and

decisions, and minimize their focus on governance decisions in their

investee companies. Moreover, managers of institutional shareholders

tend to discharge their responsibilities to their own investors by relying

upon external independent advice on voting and governance matters.

While the emergence of the proxy advisory industry represents a

whole new chapter in Indian corporate governance as it generates the

much need activism among public shareholders, it is necessary to

caution against some possible concerns that have been witnessed in

other jurisdictions. It is much too early to determine their impact in

India yet, but lessons from experiences in those jurisdictions would

play a role in better moderating the functioning of the industry in India

so as to take full advantage of its benefits by addressing any ill-effects

along the way.

B. Concerns and Possible Mitigating Factors

At a conceptual level, there are different lines of concerns raised

regarding the operation of proxy advisory firms. These concerns

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have emanated globally in the industry, and are not specific to India,

where the experience with the industry is fairly new. First, proxy

advisory firms may suffer from conflicts of interest, either actual

or potential, that may impinge upon the independence and

impartiality of their recommendations. Proxy advisory firms comprise

both for-profit entities that must raise revenues to carry on their

business, and some non-profit entities. While for-profit entities

mainly charge their customers (being institutional investors) a fee for

the advisory services rendered, some firms also seek other income by

offering consultancy services. Often, such services, which are in the

nature of governance consultancies, are provided to listed companies.

This raises conflict concerns, as the independence of recommendations

put out in respect of such companies is not beyond doubt. It is not

known if such conflicts have manifested in the Indian context yet, but

it is useful to take cognizance of international practices that have

emanated.

Second, there are concerns regarding the policies followed by the

proxy advisory firms while conducting their research and issuing

recommendations. One of the criticisms is that the governance

methodologies and metrics developed and utilized are too general and

do not pay sufficient attention to the specificities involved in each

company. For example, there could be a tendency to adopt a check-

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the-box or one-size-fits-all approach, without delving into the

circumstances that operate in each company or with respect to

different proposals. Excessive standardization of recommendations will

have the effect of substantially diluting their value, and

obliterating the contributions that proxy advisory firms can make

towards better corporate governance.

Third, the functioning of proxy advisory firms can be subjected to more

optimal monitoring with a robust legal regime that clearly delineates

the legal responsibility and liability of proxy advisory firms for the

advice they provide. Currently, such a regime does not exist in India.

At most, firms may be responsible contractually for the advice they

provide to institutional investors with whom they have a contractual

relationship. Responsibility for a wider audience in the form of

retail investors for public recommendations is even remote. The

absence of such a regime for responsibility could potentially threaten

the full utilization of the proxy advisory industry as an effective

corporate governance intermediary.

At a broad level, some of the concerns raised may be addressed either

by market forces or by governmental regulation. A market-based

approach would rely on a number of high quality players in the

industry to enhance standards through competitiveness. This would

necessitate the presence of a larger number of players in the

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industry as opposed to the current oligopoly situation witnessed in the

market, both in India and globally. The shortcoming of relying purely

on a market-based approach is evident from other sectors in the

corporate governance field, such as credit rating agencies and large

accounting firms, where a limited number of large players dominate the

industry.

On the other hand, proxy advisory firms are subject to virtually no

governmental regulation. Since the lack of a legal regime governing the

industry would exacerbate the issues such as conflicts of interest and

the inadequacies in transparency standards, leading economies

around the world are actively considering reform efforts to rein in

proxy advisors. Proposals for regulating the proxy advisory industry

are under active consideration in Europe, the United States and

Canada.

In India, proxy advisory firms do not fall within any specific

regulatory oversight mechanism. Given the industrys nascence, SEBI,

which may have the closest domain relationship with such firms, has

not yet taken any steps to regulate it. At the same time, there have

been calls for SEBI to initiate steps to regulate the industry and lay

down standards of service to be provided by proxy advisory firms.

This would require the establishment of a registration mechanism for

such firms, which would ensure that only those firms with basic

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qualifications and competence levels will be permitted to carry on the

business, thereby instituting high entry-barriers. This would help

maintain high quality standards in the industry. Such a registration

mechanism would also help SEBI monitor the actions of the firms, and

also to impose sanctions in the event of non-compliance with services

standards. This would be similar to the regulation of credit rating

agencies, whereby SEBI has been effective in maintaining standards

within the Indian industry, although the industry at the wider global

level had come under some criticism due to its role in the sub-prime

crisis.

C. Other Informational Intermediaries

Apart from proxy advisory firms, other types of intermediaries are

beginning to cast their spell on Indian corporate governance. The year

2012 has witnessed several analysts publishing reports regarding

various Indian leading companies on matters that range from

accounting practices to governance standards to the role of controlling

shareholders. By highlighting issues regarding governance of

companies, which extends beyond the traditional confines of financial

analysis, these intermediaries are imposing considerable pressure on

managements and controlling shareholders to re-examine their own

governance standards and practices. This will lend itself to greater

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transparency, as the availability of more information and deeper

analysis will enable investors to take a more informed view of their

investments.

However, this phenomenon is very recent, and its impact on overall

governance standards is yet unknown. In any event, certain recent

reports issued by analysts have been surrounded by their own share of

controversies. Not only have these reports been strongly refuted by

companies and their managements, in one case a criminal complaint

was even filed by the company concerned against the analyst firm

and the individuals who authored the report. For these reasons, a

more detailed consideration of the impact of these analyst firms as

informational intermediaries on Indian corporate governance must

await another day.

6. Feasibility of Interactive/Combative Strategies

After having considered the measures adopted by the regulators and

the industry to enhance shareholder participation, it is now

appropriate to explore the trends and strategies that activist investors

may adopt by directly interacting with their investee companies in

India and, if those result in failure, by undertaking more severe

measures such as bringing about a change in control of the companies

27

or even litigating against the companies, their directors and

management.

A. Interactive Strategy

Some types of investors, such as private equity funds, venture capital

funds and even hedge funds engage in relationship investing, which

involves a long-term relationship between the investors and the

company. In this arrangement, investors are in close contact with

management and they also tend to provide strategic advice to

management that is beneficial not only to the company but also

indirectly preserves (or even enhances) value to the investors in the

stock they hold. While it is likely that such interactive efforts are being

undertaken in the Indian context too, whereby institutional investors

influence corporate governance in companies, their effect is hard to

measure. As such interaction takes place in confidence, trends cannot

be discerned due to the absence of publicly available information.

While interactions between investors and companies are useful in

corporate governance, there are some limitations to this approach in

India. First, companies are under no legal obligation to engage with

investors. Their obligations extend to providing information as

required by company law and securities regulation, which is uniform

for all investors. Specific investors are entitled to seek further

28

information regarding certain matters, such as inspection of the

register and index of members and debenture-holders and minutes of

shareholders meetings. Other details such as additional financial

information and even minutes of board meetings need not be provided

to individual investors. Second, companies could find themselves in

violation of the law if they selectively provide sensitive information to

specific investors. Under the SEBI (Prohibition of Insider Trading)

Regulations, 1992, insiders such as directors and managerial personnel

are not permitted to communicate or counsel or procure directly

or indirectly any unpublished price sensitive information to any

person While the regulations on insider trading do not prohibit

discussions with institutional investors, several constraints are imposed

on the conduct of such discussions. Listed companies are required to

maintain and adhere to a code on corporate disclosure practices.

Under such a code, listed companies can provide only publicly

available information to institutional investors or analysts. Any

specific information provided to such investors must be

simultaneously made public. The regulations impose other checks

and balances to ensure that discussions with institutional investors do

not provide them with an advantage unavailable to other investors in

the market.

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While interaction between investors and companies is possible, the

significant constraints imposed on that process might limit its

effectiveness as a tool to influence governance in Indian companies.

B. Change of Control Strategy

Where mere interaction with management is found to be inadequate

or ineffective, it is common for activist investors to advance to the

next stage of confronting management with efforts to displace them. In

several jurisdictions, it is not unusual for investors in such cases to

initiate proxy wars and control fights to replace incumbent

managers with new ones who may be amenable to the views of

the activist investors regarding the business and strategy for

the company. Often, activist investors have indeed succeeded in

replacing managements that have resisted their efforts.

However, in India, it is unlikely that such efforts towards change

in control are likely to succeed. Most public listed companies in India

continue to have controlling shareholders (or promoters), barring a

handful that has diffused shareholding. Given that the controlled

company structure is predominant in the Indian corporate landscape,

any attempt by activist investors to seek control of Indian companies

would encounter significant obstacles. The concept of hostile

takeovers, which is the common form of control seeking mechanism,

30

is almost non-existent in India with only a few such having been

attempted and even fewer having succeeded.

For these reasons, it is necessary to remain pessimistic about the

utility of hostile takeovers and proxy fights as weapons in the arsenal of

activist investors in Indian companies. While they may be effective in

other jurisdictions with diffused shareholding, the viability of such

mechanisms in controlled companies that are omnipresent in India

remains doubtful. The situation might likely change in the future with

the growth of retail investment and reduction in controlled

shareholder blocks because listed companies are now required to have

at least a minimum of 25% public shareholding (which is reduced to

10% in the case of government companies).

C. Litigation Strategy

Internationally, activist investors have also resorted to litigation in

extreme cases where boards and managements of companies have

acted in a manner that investors believe has caused loss either to the

companies or their shareholders. On occasions, they have even

succeeded. Whether such a litigation strategy would be effective in

achieving the activist investors goals of enhancing corporate

governance and shareholder value in Indian companies is a widely

31

open question. However, as this report details further, the outlook is

bleak.

Shareholder suits form a useful method of enforcing corporate law

and governance norms through private mechanisms. The

advantage of this method is that the enforcement can be controlled

by an affected shareholder rather than to rely upon public

enforcement that is controlled by the state. Under corporate law,

shareholder may bring principally two types of actions. The first is a

derivative action, whereby a shareholder may sue on behalf of the

company in respect of a loss caused to the company. The classic

instance where derivative action is an effective shareholder remedy

is when the directors or officers of a company have breached their

duties to their company, but the board decides not to initiate legal

action against them. In such a case, the derivative action enables the

shareholder to bring a suit on behalf of the company against the

offending party. If the suit is successful, the company will enjoy the

remedies. For instance, any recoveries under the suit will inure to the

benefit of the company rather than the shareholders. The second type

is a direct action. Here, the shareholder brings a suit against the

company, its board, management or other shareholders for the breach

of a duty owed to the shareholder. In such case, the shareholder can

bring a suit for its own benefit and the remedies would inure to the

benefit of the shareholder, who may enjoy it directly. For instance, any

32

recovery or benefit under a direct shareholder suit will accrue to the

shareholder, and generally not to the company.

Company law in India provides shareholders with the options of

bringing both a derivative suit and a direct suit if their interests are

adversely affected and a cause of action arises under law. However,

these remedies are arguably not fully effective. The remainder of this

section deals briefly with each of these types of actions and why they

may or may not be viable options to activist shareholders.

7. Evaluating the Impact of Shareholder Activism

After considering the trends regarding shareholder activism that

are emanating from India, and assessing the possibilities and

limitations within the Indian context, it is necessary to evaluate the

effectiveness of such activism as a measure of enhancing corporate

governance, both generally as well as in the specific context of India.

A. Distilling the Evidence

The present study finds palpable anecdotal evidence that indicates a

greater role on the part of activist shareholders in India since 2011

than that witnessed in the past. This is due to the efforts of the

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corporate regulators to enhance shareholder participation in corporate

decision-making through various measures such as e-voting, e-

meetings and the imposition of a stewardship role on institutional

investors such as mutual funds. Apart from being nudged by the

regulators, certain activist investors themselves have taken on the

mantle of influencing corporate governance in companies in which

they have invested. The emergence of a strong set of informational

intermediaries in the form of proxy advisories signals a new era in

shareholder activism in India. Although it is too early to determine the

impact of these measures on Indian corporate governance, it is

reasonable to expect the momentum towards shareholder activism

and (away from passivity) to continue in the near future.

While some general trends in India can be gleaned from anecdotal

evidence, there is little track record to build any empirical evidence

yet. Although there are empirical studies carried out in other markets,

they remain equivocal about the positive impact of

shareholder activism on corporate governance. A number of reasons

have been offered, that range from the methodological to the

substantive. At the outset, there are difficulties in measuring the

effectiveness of shareholder activism. For instance, there is often no

public evidence of the interactive efforts of shareholders to influence

corporate governance in investee companies. Moreover, there are

difficulties in establishing the causal link between activism and better

34

corporate governance. Even when measurable, the results have not

been convincing, as the impact appears to be quite feeble. As Gillan

and Starks note:

The evidence provided by empirical studies of the effects of

shareholder activism is mixed. While some studies have found positive

short-term market reactions to announcements of certain kinds of

activism, there is little evidence of improvement in the long-term

operating or stock-market performance of the targeted companies.

On the other hand, it has been argued that the significant costs

generated by shareholder activism cannot justify the limited benefits it

confers.

Concerns have also been expressed about the possible negative impact

of some forms of activism, such as the type pursued by hedge funds.

The natural assumption is that any value created by activist

shareholders is equally enjoyable by the other passive investors, which

arises due to the overall enhancement of governance standards in the

company. But, that assumption is not necessarily valid in all

circumstances. Activist investors may likely pursue agendas not

shared by and often in conflict with those of passive investors.

Moreover, institutional investors are subject to inherent conflicts of

interest. Although they may hold shares for the benefit of their own

35

investors (such as unit-holders in a mutual fund), it is the managers

who exercise voting rights in the investee companies. There is a risk

that the activist approach may be beneficial to the managers, but not

necessarily in the interests of the ultimate investors or unit-holders in

the institution. While there is yet no evidence of such a distinct

conflict that has emanated in India, the importance of its adverse effect

on shareholder activism cannot be ignored.

While the anecdotal evidence indicates the strong emergence of

shareholder activism in India, the empirical evidence regarding its

impact on corporate governance in other markets is mixed. Given this

situation, the benefits of shareholder activism as a measure to boost

corporate governance in India must be accepted with some caution.

B. Effect on Controlled Companies

While evaluating the impact of shareholder activism, regard must be

had to the ownership structure of companies. Activism may have a

different effect on companies with controlling shareholders as opposed

to those without. For example, in companies without controlling

shareholders, the influence of activist shareholders and increased

voting by shareholders may have a direct bearing on the

outcome of proposals made by management. On the other hand,

36

where controlling shareholders are dominant, it is unlikely that efforts

on the part of the regulators to promote shareholder voting or activist

stances adopted by certain institutional shareholders will have the

same effect as in companies with diffused shareholding. As Bebchuk

and Hamdani note:

In [ companies with controlling shareholders] , the rules governing

voting procedures are likely to be inconsequential. Controllers-

unaffected by the collective action and free-rider problems that

discourage action by dispersed shareholders-will exercise their voting

power even without rules to facilitate shareholder voting.

Furthermore, as long as a controller has enough votes to determine

voting outcomes, even rules that facilitate voting by minority

shareholders will not enable them to pass resolutions not favored

by the controller.

In insider economies such as India, due to the influence of controlling

shareholders, activist investors would not find it easy to alter the

outcome of decisions made at shareholders meetings. This may in turn

reduce the incentives of activist investors to adopt stances that

operate to act as a check on management. As a corollary, controlling

shareholders are less likely to be deterred by the actions of activist

shareholders.

37

In a study that is specific to India, Geis has conceptually and

empirically demonstrated that while independent blockholding by

institutional investors is generally useful in theory, it is unlikely to

have any impact on corporate governance in India due to the current

ownership structure of Indian companies with concentrated

shareholding.

Hence, if there is some ambivalence regarding the effectiveness of

shareholder activism generally, then its positive effect on controlled

companies that populate the Indian corporate setting is only likely to

be minimal.

In concluding this section, we find that while shareholder activism does

influence corporate governance in several ways, not the least by

publicizing governance failures and drawing attention to specific issues

that may be of relevance to the investing community, we are far

from finding any empirical correlation between shareholder activism

and corporate governance. If that link is not clear in developed

markets such as the US with companies that have diffused

shareholding, we must accept shareholder activism in insider

economies like India that have controlled companies with some

amount of caution. While it would be rash to argue against activism,

its impact must not be overstated.

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8. Conclusion

This report traces the evolution of shareholder activism in India.

Hitherto non-existent, the phenomenon has been ushered into Indian

corporate governance within a span of the last two years. It has been

facilitated through regulatory reforms that enable greater participation

of shareholders in corporate decision-making. More than that, a

market environment for activist investors and corporate governance

intermediaries has rapidly taken shape in India. The proliferation of

proxy advisory firms issuing recommendations in respect of

hundreds of Indian listed companies, and high-profile examples of

institutional investors such as hedge funds confronting Indian

managements is emblematic of the trend.

However, the corporate structure and legal system in India offer

considerable resistance that prevents full utilization of the benefits

of shareholder activism. The existence of controlling shareholders in

most Indian companies cushions the impact of activist investors. The

legal system is not conducive to shareholder litigation, which is a tool

utilized by activist investors in other jurisdictions, often successfully. At

an overall level, there is also some pessimism about the impact of

shareholder activism on the long-term performance of companies and

shareholder value.

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In building upon the present study, future efforts may be undertaken

on two fronts. First, there is a need for greater empirical research on

the impact of shareholder activism in India, which would help better

understand its desirability and effect in the Indian context. Second,

more efforts must be taken to enhance the power of minority

shareholders who are compelled to act in the shadow of controlling

shareholders. These include measures such as cumulative voting for

appointment of independent directors, prohibition on controller

shareholder voting in case of interested party transactions, and the

like. If such an enabling regime were created, it would provide the

necessary incentives to activist shareholders to bring about overall

enhancement of corporate governance norms in the listed companies

in which they have invested, and also generally raise governance

standards within the country.