Barack Obama on the The Financial Crisis Responsibility Fee "to be imposed on major financial firms till the American tax payer is fully compensated" of the $117 billion bailout cost.
Read on!
Saturday, January 16, 2010
Interesting Reads
Nobel Laureate Paul Krugman on "Bubbles And The Banks" In The New York Times. Krugman says its high time reform takes on financial industry's compensation practices. Elsewhere, Thomas Friedman wonders if going short on China really makes sense in Whether China Is The Next Enron?.
Sunday, January 10, 2010
Why the Class Action Remedy Proposed In the New Companies' bill Will Fail
The "Economic times" recently published a debate on the efficacy of the class action remedy proposed by the new Companies' Bill on January 6, 2010. (Found Here and Here).
In a nutshell, the pro/con seems to be,
1.) Yes; Class actions may be useful but possibilities of the misuse of the device ought to be foreclosed. Class Action remedies ought to be coupled with statutory prescriptions that limit speculative litigation.
2). The counterview, posited by the President of a regional investor association seems to be that class action is a remedy whose time has come and "defaulting promoters" ought to be held accountable.
Seems to be me that debaters missed a vital dimension; the incentive structure in the legal services market.
If one factors in this dimension, the class action remedy will most likely be under-utilized, and therefore fail, in most respects.
Here is a capsule low-down:
The Class action remedy is one of the latest transplants that India has borrowed from Anglo-Saxon corporate law and more particularly, the US. But while engaging in this eclecticism, precious little thought has gone into the peculiar institutional design that makes the class action remedy favourable in the US market.
The reason why class actions were successful in the US (in fact so, successful, that speculative litigation abounded, prompting the House to enact the PSLRA, 1995, to regulate causes of action and standi) was the incentive structure of the legal services market. In the US, unlike India, as most of us might be well aware, the incentive structure is characterized by contingency fees.
In their design, contingency fee arrangements replicate the risk-sharing model where the attorney of the plaintiffs takes an "equity interest" in the "litigation venture". Consequently, while the lawyer stands to reap windfall gains should the class action succeed, the returns may be substantially lesser if the action fails.
These rules of the game in the legal services reduce transaction costs, agency risk and result in a robust market for class actions; With her incentives aligned to those of the class acting plaintiffs, the lawyer is much more pro-active in faster "turn around" times.
Contrast this market design, with the "lodestar rule" prevalent in India that de-links the attorney's incentives from the outcome of the litigation to its process--the hours that she dedicates for the client/appearance that she makes for the clients in courtrooms. To make matters worse, institutional rules of the game forbid "opt-out" of this inefficient rule by foreclosing contingency fees as an option.
With the lode-star rule in place, I doubt that aggrieved investors will have appropriate motivations to pursue class action remedy. Admittedly, the class action device reduces the cost of litigation for the plaintiffs. However, the disincentives created by the lode-star rule will make it highly unlikely that the law firm that they engage, will advise them correctly as to which actions to pursue to trial and which actions to settle. And if so, they will prolong most actions that they should have settled earlier, adding to the cost of litigation. Class actions in securities fraud cases are likely to be complex (causation is notoriously difficult to prove, unless the rules of evidence are changed to reverse the burden of proof) and this information asymmetry between the principal(plaintiff investors) and the agent (attorney) coupled with the perverse incentive structure make this scenario much more likely.
In a nutshell, the pro/con seems to be,
1.) Yes; Class actions may be useful but possibilities of the misuse of the device ought to be foreclosed. Class Action remedies ought to be coupled with statutory prescriptions that limit speculative litigation.
2). The counterview, posited by the President of a regional investor association seems to be that class action is a remedy whose time has come and "defaulting promoters" ought to be held accountable.
Seems to be me that debaters missed a vital dimension; the incentive structure in the legal services market.
If one factors in this dimension, the class action remedy will most likely be under-utilized, and therefore fail, in most respects.
Here is a capsule low-down:
The Class action remedy is one of the latest transplants that India has borrowed from Anglo-Saxon corporate law and more particularly, the US. But while engaging in this eclecticism, precious little thought has gone into the peculiar institutional design that makes the class action remedy favourable in the US market.
The reason why class actions were successful in the US (in fact so, successful, that speculative litigation abounded, prompting the House to enact the PSLRA, 1995, to regulate causes of action and standi) was the incentive structure of the legal services market. In the US, unlike India, as most of us might be well aware, the incentive structure is characterized by contingency fees.
In their design, contingency fee arrangements replicate the risk-sharing model where the attorney of the plaintiffs takes an "equity interest" in the "litigation venture". Consequently, while the lawyer stands to reap windfall gains should the class action succeed, the returns may be substantially lesser if the action fails.
These rules of the game in the legal services reduce transaction costs, agency risk and result in a robust market for class actions; With her incentives aligned to those of the class acting plaintiffs, the lawyer is much more pro-active in faster "turn around" times.
Contrast this market design, with the "lodestar rule" prevalent in India that de-links the attorney's incentives from the outcome of the litigation to its process--the hours that she dedicates for the client/appearance that she makes for the clients in courtrooms. To make matters worse, institutional rules of the game forbid "opt-out" of this inefficient rule by foreclosing contingency fees as an option.
With the lode-star rule in place, I doubt that aggrieved investors will have appropriate motivations to pursue class action remedy. Admittedly, the class action device reduces the cost of litigation for the plaintiffs. However, the disincentives created by the lode-star rule will make it highly unlikely that the law firm that they engage, will advise them correctly as to which actions to pursue to trial and which actions to settle. And if so, they will prolong most actions that they should have settled earlier, adding to the cost of litigation. Class actions in securities fraud cases are likely to be complex (causation is notoriously difficult to prove, unless the rules of evidence are changed to reverse the burden of proof) and this information asymmetry between the principal(plaintiff investors) and the agent (attorney) coupled with the perverse incentive structure make this scenario much more likely.
Saturday, March 14, 2009
Another Case Of Regulatory OverReach under the Take Over Code?
In a recent adjudicating order, Adjudicating Order No.VSS/AO-27-2009, that may be viewed here, SEBI found that the Directors of a "Non Promoter Controlled Company", Matra Realty Limited were obligated to disclose their share holdings pursuant to the Disclosure law in the Take over Code. The SEBI found that the Directors were "persons having control over the company" within the meaning of relevant regulations [6(3) & 8(2)] and therefore were required to disclose their share holding to the company. It seems to me that this is yet another case of regulatory overreach. Conceding that the relevant provisions of the take over code distinguish between promoters and persons having control over the Company; the expression, "persons having control over the company" cannot in the context of the take over Code disclosures mean Directors of the Company. Let us therefore analyse this latest juridical wisdom that comes from the regulator.
The adjudicating officer found that the expression "control" is defined inclusively in the Take over Code. Regulation 2(1)(c) defines Control as:
“control” shall include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner.
Thus Control includes the right to a) appoint majority of directors b) (the right to) control the management or policy decisions. Further such right(s) are exercisable bby a person acting individually or in concert. And lastly, such right(s) of Control as above stated were tracable to (should emanate from) such sources as their share holding, management rights, share holders Agreements, voting agreements or analogues thereof. Again here, the sources of the right to exercise control are inclusive.
The adjudicating officer found that the above definition meant:
"any person who controls the management of a company either individually or collectively with other persons or controls or influences the policy decisions, by virtue of his position can be said to be in ‘control’ over the affairs of the company... a Director is one of the controller of companies affairs. The Board Of Directors is the brain of the Company. When the Board functions, the Company is said to function. Thus the functioning of the Company is totally controlled by the Board..."
Further, having analysed the share holding pattern, he finds that the Directors and PACs were the largest share holders in the Corporation as they held 13.75% together with their PACs as of 2004.
"In view of the foregoing", he finds that the Directors are "in control" of the Corporation and having not disclosed, finds them not compliant with the law.
Thus the analysis seems to rest on two main premises: Firstly, the Directors had control over the Company by virtue of their position. Secondly, they were the single largest share holders of the Company, taken together with their PACs.
If this is the case, the analysis is faulty;
even conceding that the definition of control is inclusive and that the sources from which Control rights emerge is (also) inclusive, the analogues are to be considered ejusdem generis to the more particular words used in the definition. The sources of Control rights that the definition speaks of are :
a) share holding b) share holding agreements 3) voting agreements 4) management rights. So, the analogues, applying ejusdem generis, should only include Control rights that are "contractual" in orgin.
Directors of a Company, in contrast, receive their power/right to manage the corporation from the Companies Act. The Companies Act mandates that there should be a Board Of Director and articulates the powers of the Board (See for e.g. Section 291/292 of the Companies Act that speak of "Powers of the Board"). Their source of "Controlling power" (or Controlling Rights, leaving aside the jurisprudential difference between "Power" and "Right"), is the Statute and therefore those rights have a "in rem" origin rather than "in personam" origin that Contractual rights have. Consequently , the Control that they exercise over the Corporation pursuant to the powers under the Companies Act cannot be read in the understanding of control that we have under the Take Over Code. ( because the illustrative sources of Control rights in the Take Over code are only Contractual in origin).
Finally, the reliance of the adjudicating officer on the share holding of the Directors and the PACs taken together being the largest was incorrect.
It is clear that the powers that the Board exercised over the Company were traced to or emanated from their position/status as Directors ofthe Company. The source of the power to control the management or policy decisions emanated from their position as Directors. The source of that power/right was NOT their share holding. So,it need not have figured in the analysis at all. (indeed if the control rights emanated by virtue of them being the largest share holders, Control as understood in the take over Code is triggered. See, the definition of "Control" above. But the Right/Power of taking Management decisions emanates from the Statute as we saw earlier).
A case of regulatory overreach (again)?
The adjudicating officer found that the expression "control" is defined inclusively in the Take over Code. Regulation 2(1)(c) defines Control as:
“control” shall include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner.
Thus Control includes the right to a) appoint majority of directors b) (the right to) control the management or policy decisions. Further such right(s) are exercisable bby a person acting individually or in concert. And lastly, such right(s) of Control as above stated were tracable to (should emanate from) such sources as their share holding, management rights, share holders Agreements, voting agreements or analogues thereof. Again here, the sources of the right to exercise control are inclusive.
The adjudicating officer found that the above definition meant:
"any person who controls the management of a company either individually or collectively with other persons or controls or influences the policy decisions, by virtue of his position can be said to be in ‘control’ over the affairs of the company... a Director is one of the controller of companies affairs. The Board Of Directors is the brain of the Company. When the Board functions, the Company is said to function. Thus the functioning of the Company is totally controlled by the Board..."
Further, having analysed the share holding pattern, he finds that the Directors and PACs were the largest share holders in the Corporation as they held 13.75% together with their PACs as of 2004.
"In view of the foregoing", he finds that the Directors are "in control" of the Corporation and having not disclosed, finds them not compliant with the law.
Thus the analysis seems to rest on two main premises: Firstly, the Directors had control over the Company by virtue of their position. Secondly, they were the single largest share holders of the Company, taken together with their PACs.
If this is the case, the analysis is faulty;
even conceding that the definition of control is inclusive and that the sources from which Control rights emerge is (also) inclusive, the analogues are to be considered ejusdem generis to the more particular words used in the definition. The sources of Control rights that the definition speaks of are :
a) share holding b) share holding agreements 3) voting agreements 4) management rights. So, the analogues, applying ejusdem generis, should only include Control rights that are "contractual" in orgin.
Directors of a Company, in contrast, receive their power/right to manage the corporation from the Companies Act. The Companies Act mandates that there should be a Board Of Director and articulates the powers of the Board (See for e.g. Section 291/292 of the Companies Act that speak of "Powers of the Board"). Their source of "Controlling power" (or Controlling Rights, leaving aside the jurisprudential difference between "Power" and "Right"), is the Statute and therefore those rights have a "in rem" origin rather than "in personam" origin that Contractual rights have. Consequently , the Control that they exercise over the Corporation pursuant to the powers under the Companies Act cannot be read in the understanding of control that we have under the Take Over Code. ( because the illustrative sources of Control rights in the Take Over code are only Contractual in origin).
Finally, the reliance of the adjudicating officer on the share holding of the Directors and the PACs taken together being the largest was incorrect.
It is clear that the powers that the Board exercised over the Company were traced to or emanated from their position/status as Directors ofthe Company. The source of the power to control the management or policy decisions emanated from their position as Directors. The source of that power/right was NOT their share holding. So,it need not have figured in the analysis at all. (indeed if the control rights emanated by virtue of them being the largest share holders, Control as understood in the take over Code is triggered. See, the definition of "Control" above. But the Right/Power of taking Management decisions emanates from the Statute as we saw earlier).
A case of regulatory overreach (again)?
Monday, February 2, 2009
Satyam Pricing Relaxation- Does SEBI Have Ex ante Competence "To Consider"?
News Paper reports suggest that the securities regulator is "considering" a proposal to link the open offer price of Satyam Computer Services, to the average price of the stock in a shorter and more recent period. This is apparently been done because potential "white knights" who "d want to acquire Satyam, under the extant take over regulations, face the prospect of coughing up Rs. 270 per share; this is as required by the formula prescribed under regulation 20 that prescribes higher of the average price of the stock for 26 weeks or two weeks.
Basically therefore, The price of Rs.270 is causing a "chilling effect" on potential white knights and so the regulator is contemplating this "regulatory discount"...
There are many issues that arise from this chain of events; But implicit and the more important of these is that of regulatory competence to allow such waivers from the provisions of Chapter III of the Take over Code. SEBI seems to have assumed that such a power is existent ; but thats not entirely clear.
The scheme of the Take over Code is clearly indicative of the fact that Regulation 3 of the same is complete code so far as exemptions go. Now, within the scheme of Regulation 3, we have a residual clause 3(1)(f) that reads as under :
"Other cases as may be exempted from the applicability of Chapter III by the Board under Regulation 4"
Regulation 4 then provides that
"The Board shall for the purposes of this regulation constitute a panel of majority of Independent persons from....."
The later sub clauses of Regulation 4 then carve out the procedure to seek an exemption under the above referred sub clause. The scheme of this procedure is such that the Board is merely a "Conduit" to allow passage of the application from the acquirer to the Panel and it is the Take Over Panel ( Not the SEBI Board) that has the first power to "Recommend" whether the exemption ought to be given or not. It is only after the Panel has communicated its views to the Board, the Board shall..... after considering all the relevant facts including the recommendations, if any, pass a reasoned order on the appplication.
It seems therefore that the powers of the Regulator to "Consider" the exemption are triggered at a stage after and not before the recommendations from the take Over panel are received.
Before the Take Over panel is seised, Its role is merely that of a "conduit" to relay the application from the acquirer.
Also, even this power to decide on the exmption is exercisable by the regulator, only in the specific context of an application from the acquirer. At the present instant, No acquirer has made a formal application for exemption. It seems from the reports that the regulator is contemplating the two week average as a floor price that potential acquirers will have to improve upon. Clearly then, it does seem that the nature of the exemption contemplated by the regulator is blanket in character..
One might rightfully then question the regulator's own "Corporate governance and compliance" when it engages in this exercise of exempting potential white knights from the rigour of the law....?
Et Tu SEBI?
Basically therefore, The price of Rs.270 is causing a "chilling effect" on potential white knights and so the regulator is contemplating this "regulatory discount"...
There are many issues that arise from this chain of events; But implicit and the more important of these is that of regulatory competence to allow such waivers from the provisions of Chapter III of the Take over Code. SEBI seems to have assumed that such a power is existent ; but thats not entirely clear.
The scheme of the Take over Code is clearly indicative of the fact that Regulation 3 of the same is complete code so far as exemptions go. Now, within the scheme of Regulation 3, we have a residual clause 3(1)(f) that reads as under :
"Other cases as may be exempted from the applicability of Chapter III by the Board under Regulation 4"
Regulation 4 then provides that
"The Board shall for the purposes of this regulation constitute a panel of majority of Independent persons from....."
The later sub clauses of Regulation 4 then carve out the procedure to seek an exemption under the above referred sub clause. The scheme of this procedure is such that the Board is merely a "Conduit" to allow passage of the application from the acquirer to the Panel and it is the Take Over Panel ( Not the SEBI Board) that has the first power to "Recommend" whether the exemption ought to be given or not. It is only after the Panel has communicated its views to the Board, the Board shall..... after considering all the relevant facts including the recommendations, if any, pass a reasoned order on the appplication.
It seems therefore that the powers of the Regulator to "Consider" the exemption are triggered at a stage after and not before the recommendations from the take Over panel are received.
Before the Take Over panel is seised, Its role is merely that of a "conduit" to relay the application from the acquirer.
Also, even this power to decide on the exmption is exercisable by the regulator, only in the specific context of an application from the acquirer. At the present instant, No acquirer has made a formal application for exemption. It seems from the reports that the regulator is contemplating the two week average as a floor price that potential acquirers will have to improve upon. Clearly then, it does seem that the nature of the exemption contemplated by the regulator is blanket in character..
One might rightfully then question the regulator's own "Corporate governance and compliance" when it engages in this exercise of exempting potential white knights from the rigour of the law....?
Et Tu SEBI?
Saturday, January 10, 2009
The Vexed Issue Of Independent Directors-II- The Solutions
[continued...]
I think one of the policy alternatives that the State ought to consider is by way of tightening the ex post law activation and enforcement.
Say have a law to provide Class action litigations.
Once the Directors know that there are expedited judicial processes to aid the share holders which disperse litigation costs and risks, ex ante, there will be considerable incentives to act in a manner befitting their fiduciary status. The Independent Directors also will be more agile in monitoring the executive component of the Board.
The problem with placing too much reliance on Institutional Share holders to do the monitoring and to let retail share holders to piggy back is that with portfolio holdings, Institutional share holders hardly have any inclination to monitor their agents. (Although there are instances recently where activist hedge funds did a very good job of monitoring. (Sterlite's failed restructuring).
But its not going to be easy to bring a Class action law on the statute books. For one, its going to add to the cost for Corporates. I see an immediate uopward revision in the D& O liability Insurance premium for example. Also, the possibilty of being found party to a law suit at a later date will act as an ex ante disincentive for the Independent Director to accept the post. ( we have a very recent example of Nimesh Kampani in Nagarjuna Finance)
Also, easier access to remedy ex post might lead to ex ante laxity in monitoring the Boards among the share holders. Clearly, the field is ripe for research!
Should the SRO have a say in appointment of Independent Directors, that might be quasi nationalisation ; management rights to an enterprise are after all a form of property.
May be a peer review mechanism that uses reputation costs as a tool for deterrence can be used in appointment of Independent Directors. That will augment the formal deterrence mechanisms that the legal system provides. This is especially because, Satyam showed that investors factor in corporate governanxce standards in the secondary market. We saw the sensex reacting negatively and FIIs pulled ouit their money. The peer review mechanism will act as an ex ante hedge against the Company appointing Independent Directors with suspect affliation.
I think one of the policy alternatives that the State ought to consider is by way of tightening the ex post law activation and enforcement.
Say have a law to provide Class action litigations.
Once the Directors know that there are expedited judicial processes to aid the share holders which disperse litigation costs and risks, ex ante, there will be considerable incentives to act in a manner befitting their fiduciary status. The Independent Directors also will be more agile in monitoring the executive component of the Board.
The problem with placing too much reliance on Institutional Share holders to do the monitoring and to let retail share holders to piggy back is that with portfolio holdings, Institutional share holders hardly have any inclination to monitor their agents. (Although there are instances recently where activist hedge funds did a very good job of monitoring. (Sterlite's failed restructuring).
But its not going to be easy to bring a Class action law on the statute books. For one, its going to add to the cost for Corporates. I see an immediate uopward revision in the D& O liability Insurance premium for example. Also, the possibilty of being found party to a law suit at a later date will act as an ex ante disincentive for the Independent Director to accept the post. ( we have a very recent example of Nimesh Kampani in Nagarjuna Finance)
Also, easier access to remedy ex post might lead to ex ante laxity in monitoring the Boards among the share holders. Clearly, the field is ripe for research!
Should the SRO have a say in appointment of Independent Directors, that might be quasi nationalisation ; management rights to an enterprise are after all a form of property.
May be a peer review mechanism that uses reputation costs as a tool for deterrence can be used in appointment of Independent Directors. That will augment the formal deterrence mechanisms that the legal system provides. This is especially because, Satyam showed that investors factor in corporate governanxce standards in the secondary market. We saw the sensex reacting negatively and FIIs pulled ouit their money. The peer review mechanism will act as an ex ante hedge against the Company appointing Independent Directors with suspect affliation.
Friday, December 19, 2008
The Vexed Issue Of Independent Directors
The recent Corporate Governance fiasco at Satyam raises some interesting issues about the Economics behind the law and policy of corporate governance in India. It shows how these issues from behavoural economics remain unaddressed or imcompletely unaddressed under the compliance driven mandate of clause49.
In this piece I argue that the rule based nature of clause 49 makes the framework underinclusive to address the issues similar to those that arose in Satyam.
An analysis of the underlying theme of clause 49 makes it clear that the term "Independent Director" is defined in the context of her proximity to the promoter/promoter group/BOD. That proximity is seen in two contexts: a) familial association b)Association arising from sustained and repetitive interaction.
This theme is a hedge against moral hazard issues. So far so good. The problem however is that, clause 49 does not address the issue of moral hazard entirely.
It fails to address the issue of moral hazard that arises from being repeat players in the same business segment. Let me try and explain this argument:
If an Independent Director has to be professionally competent (and reason demands that he ought to be competent in the vertical that the firm operates in), then the market for Indepedent Directors includes professionals, and academics well known in that vertical. Now, entrepreneurs, precisely because of their lengthy association with the particular business vertical are more than likely to know these actors. Now the extent of affiliation would differ; in some cases, the affliation will not be more than casual; in others, It could go deeper ( For example, It is likely that the academic was earlier a Ph.D. guide of the entrpreneur or a college senior perhaps). Without going in to the specifics then, it is fairly reasonable to imagine that fact matrices may exist where individuals otherwise qualified within the meaning of clause 49 are "Non Independent" by virtue of moral hazard that arises from being repeat players inthe same business segment and also the sorts that arises from associations that are not familial or professional and yet have decided trappings of affinity.
The other side to this argument is that outside of Directors related to the promoter/promoter group, this is the only set of people that have the skill sets to become directors on the Board of companies operative on that vertical. (Say, for example, Vinod Dham on Satyam).
So, if clause 49 were to include this residuary class as well, acute demand supply mis matches msy arise in the market for independent directors. This again may have its own set of problems; It is reasonable to imagine for example that sitting fees might see an upward revision across the spectrum bringing with it assorted problems of agency costs and issues in Directorial remuneration.
Clearly, the quest to have an optimum SOX in India is far from over!
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