Governance conflicts in companies: How structural overhaul can help

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Management research has long established that firm ownership and management are the primary governance mechanisms for running firms effectively. Two types of conflicts or problems could occur in firms that detract from their ability to maximise returns to their shareholders. One is where the firms’ dominant owners i.e., shareholders act in dubious ways to appropriate firm value and benefit themselves at the expense of minority shareholders. The second type of conflict occurs when managers mismanage firms (typically the CXOs) to appropriate shareholders’ wealth and enrich themselves. This kind of conflict occurs when owners or shareholders are large in numbers and are widely dispersed, with each having very low, fragmented ownership. In such instances, shareholders are unable to monitor and control the activities of powerful managers who are tasked with managing the firm on their behalf. Managers can reap benefits through outsized increases in their compensation or through making specific investments that benefit them rather than the owners of the firm.

Consider the case of ICICI Bank and Chandra Kochhar. It is alleged that Kochhar, as CEO and MD of ICICI Bank, favoured the Videocon Group in 2012 by lending ₹3,250 crore as a loan from ICICI Bank. This eventually turned out to be a non-performing asset for the bank in 2017. Did the bank exercise due diligence and undertake the normal approval process before the loan was approved? When there are suspicions that managers are behaving in their self-interest, a firm’s owners should be vigilant and monitor management’s activities to ensure that managers are not sub-optimising their welfare. In the case of the ICICI bank, for example, the ownership was widely distributed with no dominant ownership blocks such as a family or the government having concentrated ownership, thus enabling better monitoring of management’s decisions. In 2012, when this transaction took place, the largest shareholder of ICICI was Deutsche Bank Trust Company Americas, a passive shareholder that had a shareholding of 29.18 percent, followed by LIC (once again a passive shareholder) with 7.20 percent ownership. Deutsche Bank, in turn, had distributed ownership with their largest shareholder being BlackRock Inc. (with only 5.14 percent shares). The few concentrated owners of ICICI Bank were themselves the managers of other professional firms. Predictably, the owners of these firms had little inclination or motivation to check the self-serving activities of ICICI managers. This absence of active monitoring might have led ICICI managers to act injudiciously in their interests rather than according to those of the firm’s owners. This problem or conflict is known as Principal (i.e., owner)-Agent (i.e., manager) or Type I agency conflict (PA conflict).

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Multiple solutions have been proposed to minimise principal-agent conflicts. These include tailoring employment contracts for the top management teams, implementing optimal compensation structures for managers, configuring board composition and structure to ensure board and director independence, and issuing shares to management personnel to align their goals with those of the owners. However, the dominant solutions proposed in these instances increase the concentration of ownership blocks. In most emerging markets such as India, ownership concentration can occur through different ownership types such as government ownership (e.g., PSUs), family ownership and/or promoter ownership. Concentrated ownership provides monitoring benefits where the concentrated and dominant owner groups can closely and effectively monitor managers to ensure that they do not engage in opportunistic self-serving behaviours that detract from creating shareholder value. Stemming from the diligent monitoring activities of these concentrated owners, an increase in concentrated ownership leads to a reduction in principal-agent conflicts in the firm. However, such concentrated ownership may also equip these dominant owners with the power and influence to control the company’s decisions as well as influence agenda-setting and strategic decision-making process. When these positions of power are combined with the motivation to pursue the concentrated owners’ private benefits rather than to increase the benefits equitably to all shareholders, it can result in a different type of conflict called Principal-Principal or type II agency conflicts (PP conflict).

Consider the contrasting case of Elcid Investments Ltd, a promoter-controlled entity of paints major Asian Paints Ltd and Hexa Tradex Ltd, an OP Jindal Group company. In May this year, the delisting proposal of Elcid Investments Ltd, failed to win the confidence of its minority shareholders, while a similar proposal by Hexa Tradex Ltd was approved by its board. Even though the outcomes of these proposals are in contrast, they had something in common—namely disagreements between majority shareholders and minority shareholders on the recommended course of action. This is the genesis of type II conflicts. In both these cases, the majority and minority shareholders experienced differences in the book values of their shares. The majority shareholders of Hexa Traders (shareholding of 63 percent) claimed that the book value of each share was Rs 400 when the stock was trading at Rs 2 in the open markets. Minority shareholders, on the other hand, claimed that the real value of Elcid which held a 4.3 percent stake in Asian Paints, was Rs 6 lakhs (a much larger sum than that offered by the dominant shareholder, Hexa Traders). They, therefore, claimed that they had to be better compensated during the delisting process. Similar was the case with Elcid Investments Ltd. where the minority shareholders were able to block the delisting of the company because they felt that the floor price offered by the majority shareholder group was much below the intrinsic value of their shares. Such kind of conflicts between the distinct groups of principals or owners (dominant versus minority groups) of a firm is referred to as principal-principal or Type II agency conflicts.

The much-discussed conflict in the Tata Group between two of its owners—Ratan Tata and Cyrus Mistry—is another prime example of the principal-principal conflict. Most Tata companies have concentrated ownership owned by Tata Sons Limited, the ’parent’ company of the diversified Tata Group. Sixty-seven (67 percent) percent of the shares of Tata Sons 6 are held by different Tata Trusts, while about 18.4 percent shareholding of Tata Sons is held by Mistry family members. Cyrus Mistry had alleged that Ratan Tata (a scion of the Tata family), through his dominant ownership of Tata Sons, interfered with the working of the Tata Group because of differences in opinion on certain courses of action undertaken by then-appointed CEO Cyrus Mistry. This created a conflict of interests and consequent suppression of the welfare of minority shareholders, such as himself.

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These circumstances place companies in an unenviable position. Trying to minimise one type of agency conflict (PA conflict) often results in increases in the other type of agency conflict (PP conflict). Our research examined this issue to identify if there are mechanisms that will simultaneously enable the minimisation of both types of agency conflicts and thereby enable wealth maximisation as per the tenets of shareholder capitalism. It is axiomatic in ‘shareholder capitalism’ that firms are obligated to maximise returns to their owners (i.e., shareholders). If they consistently abrogate those responsibilities, those firms will either find it more difficult to raise capital or at the minimum, experience a higher cost of capital. As one solution to this problem, we suggest that companies need to maintain a fine balance between having concentrated shareholder ownership along with professional managers managing these firms. Although this resonates well theoretically, how would companies in the business world implement them? Our research appears to indicate a way. In our research, we examined the optimal governance structures that firms followed for their ownership patterns and management control to reduce the combined impacts of both types of agency conflicts. Analysing 675 firms listed on the BSE and the NSE over ten years, we found that in firms that didn’t have concentrated ownership, the possibility of PA (Type I) agency conflicts was enhanced. By contrast, we found minimal evidence of PP (Type II) agency conflicts in these firms. In the sample of firms that had concentrated ownership, we examined only family business firms where the family was the dominant ownership group. We also found that in family firms, PA agency conflicts decreased significantly. We then divided family firms into two categories (based on their managers’ affiliation), namely, family-managed and non-family-managed. We found that PP agency conflicts significantly increased in family-owned and family-managed firms, primarily because dominant family share ownership combined with family management control maximised the potential for an appropriation of private benefits (for the family) to occur, at the expense of other minority shareholders of these firms. However, when non-family affiliated managers were entrusted with running these family-owned firms, the governance combination appeared to curtail the family’s ability to appropriate benefits. Consequently, such firms appeared to exhibit only moderate (or no) increases in PP agency conflicts. Taken together, our pattern of results emphasised that to simultaneously minimise, both PA and PP agency conflicts, companies need to have dominant ownership (viz., the family, in this case), coupled with having management control vested in the hands of non-family affiliated managers. Would our findings be difficult to implement in the Indian corporate world? We do not believe that they should be. But one lingering question that might arise is why would family-owned firms voluntarily relinquish their management control by appointing non-family managers to run their businesses. Business families consider their firms as extensions of their family’s wealth. Thus, passing off management control to non-family managers may be anathema to many of them. Our study suggests that unless family firms try to follow our prescriptions, they might lose their ability to attract capital on competitive terms. This becomes especially important as Indian firms seek to attract inflows of portfolio capital from international investors who are more invested in the tenets of shareholder capitalism. We are encouraged to note that some family business firms have begun to realise and act on the import of our findings.

For example, the recent decision of the Tata Group to hand over management control to a non-Tata manager, Natarajan Chandrasekaran, is we believe, a step in the suggested direction. Further, the Tata Group has introduced self-regulation to enunciate the required distinction between ownership and management control. At their latest Annual General Meeting, the shareholders of Tata Sons, the holding company of the Group, approved a significant amendment to its articles of association. It is now legally required to separate the positions of the Chairpersons of Tata Trusts and Tata Sons, respectively. This is one step towards the suggested decoupling of ownership from management. This will, as our research suggests, go a long way towards ameliorating the pernicious effects of both PA and PP agency conflicts among family business firms. Our study is equally important for firms that have other forms of dominant ownership groups such as government owners (i.e., PSUs) and Promoter Owners. That being said, the government need not necessarily dilute their ownership stakes in PSUs. Instead, it should professionalise the managerial structures among PSUs by bringing in experts from outside the government bureaucracy to professionally manage these PSUs. We recommend that this course of action will enable Indian companies to be better positioned to compete for and more favourably attract global flows of investment capital.

Prof. Saptarshi Purkayastha, IIM Calcutta (saptarshi@iimcal.ac.in) & Prof. Rajaram Veliyath, Kennesaw State University (rveliyat@kennesaw.edu)