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This has been the fate of all corporate scandals, which is why it may be better to fix the problem at the level of corporate governance standards rather than anywhere else.
Why do corporate scams happen? My answer is the caste system among shareholders.
To understand the forces at work in publicly-listed companies, it is best to view the shareholding structure as an elaborate caste system where fairness is not the ultimate objective. The idea is to maximise private gain at the cost of the majority by building a coalition of willing crooks.
Let’s begin by understanding how the caste system itself originated and evolved. The origins lie in class, where various communities accumulated knowledge, wealth and power by an admixture of hard work, fortuitous circumstances, and brute strength. Once wealth accumulates among a significant minority of people, it is in the interests of these classes to work out an arrangement that is mutually beneficial, and wealth-enhancing. Once wealth grows and gets passed on through the generations, the structure congeals into caste — the idea being to control resources for the benefit of people like us, while denying it to people like them. This is how the upper castes — brahmins, kshatriyas and vaishyas — arranged to keep wealth and power limited to themselves. The rest had to fend for themselves, at the margins.
In the Indian joint stock corporation, the promoters are the brahmins at the top. They decide everything. The key management executives — the ones with fat pay packets and Esops — are the kshatriyas. They create and run the power structure for their own benefit and that of their masters. The vaishyas are the trading community — the big market investors, favoured mutual funds, et al. At the bottom of the heap — the ones with the least power and ability to control events — are lower level employees and ordinary investors hoping to turn a rupee into two, but usually ending up with loose change. They are the shudras and untouchables — the suckers of the system.
Scams happen because the interests of the four castes are not coterminus. Rather, the top three castes feather their nests at the expense of the rest. Start with a company that is fully owned by Lala Bholenath. No internal scams are possible here because the whole company belongs to him, and looting the company is like looting himself. At stage 2, the company seeks external capital. Now, the Lala has company in terms of ownership.
Ethically speaking, he ought to treat his own interests and that of his new shareholders at par. But most Lalas don’t see it that way. As the still dominant shareholders, they see only themselves as owners and the rest as interlopers — who need to be tolerated and fed on tit-bits. This means keeping a large share of the company’s wealth away from other shareholders, either by siphoning it out or by passing on favoured contracts to family-owned entities. To do this, though, you need accomplices. This is where the top “professional” management’s role changes. From mere hired hands, they become kshatriyas — they become power centres in their own right. The owners need them to run their companies and keep the bulk of the wealth away from ordinary shareholders.
They are co-opted into it through various means — high pay packets, Esops, etc. Now, suddenly, the top employees have the same interest in defrauding shareholders and propping up the market prices of shares. This explains why Satyam’s promoters, key managers and auditors were complicit in looting the company.
But in order to really spin money for all the powerful stakeholders, you need the vaishyas — the traders and merchants. These are the big investors without whose help you can’t move share prices or bring in lots of retail investors. High net worth individuals, mutual funds, banks and foreign institutional investors (FIIs) have to be roped into the act by giving them inside dope and allowing them to make money by trading in the company’s shares. Another category of vaishyas are politicians and bureaucrats, whose palms have to be greased to keep the whole racket from breaking cover. This is the part of the Satyam scam that is now being covered up.
Companies perform well when the level of expropriation by the upper castes is moderate, and some of the overall gains filter through to ordinary shareholders in the form of high dividends and share price increases. But, by definition, the largest chunk of gains is reserved for upper caste shareholders. Now think Satyam, Raju, Vadlamani, auditors, banks, brokers and investors — all upper caste stakeholders and shareholders in our scheme of things. It made a lot of sense for all of them to collude, collaborate, or look the other way and be a party to defrauding ordinary shareholders. Through sins of omission or commission, they collectively helped money flow out of the company into Maytas and politicians’ pockets.
How can we combat this corporate caste system?
Like in real life, the joint stock corporation is here to stay, and cannot be abolished by fiat. In any case, we have nothing better to replace it with as yet. But like job quotas and other systemic changes, we can shift the balance of power.
The main remedy is to tweak the system of incentives and penalties in joint stock corporations so that the caste system is weakened. For example, Esops and top management incentives need to be made really long-term to align their interests with those of the company. When Esops vest in one, two or three years, employees have a vested interest in playing the market game and cashing out.
To stymie the vaishyas — market operators, big investors, etc — from ganging up with promoters and top management, we need to change capital gains taxes. A tax regime in which short-term capital gains tax is 15% on equity and long-term capital gains zero after one year is beneficial to traders and short-term investors, not the rest. We need a system where the tax goes down on a sliding scale every year — one should pay the top rate holding periods up to one year, 25% for two years, 20% for three years, and so on. This may not eliminate the promoter-big investor nexus, but will reduce incentives for excessive skullduggery.
The third, and most important thing to do, is to create a structural shift in power equations between majority and minority shareholders at the board level. An amendment to corporate law should allow minority shareholders to directly elect a board representative, and appoint special auditors paid for by the company. This director should have the power to veto any proposal that is against minority interests.
And special auditors should report directly to minority shareholders, not the board. For example, if a promoter wants to give himself cheap shares, the minority shareholders’ director should have a veto. At annual general meetings, resolutions in which the promoters and top managers have an interest should be voted on only by minority shareholders.
While corporate fraud are of several kinds — you can cheat the taxman, or customers — a systemic change of the kind mentioned above will reduce fraud that allows one set of shareholders to feed on the others. It will start reducing the rigours of the caste system in publicly-listed companies.