Moral Relativism

Last evening I had occasion to meet a very senior finance sector executive from the US –now involved in equity investments. He invests serious amounts of money in India, his own as well as that of others –in private equity and public markets.

While commenting on investment opportunities in India, he mentioned that valuations in India do not mean much since corporate reporting is suspect. To use his words – “why should I pay for the expenses of the promoter”? The implication was that all companies “cook” books and therefore investors were seriously disadvantaged.

I mentioned that while it may be true that many company founders tended to take some money out of the business, it appeared to me that this was not significantly different from the behavior of professional managers, especially in the US, who paid themselves disproportionately. I mentioned that I would tend to rate the behavior of Mr. Vikram Pandit of Citicorp in the same category. In my book, taking $165m (out of an estimated $800m) for selling a lemon of a fund to Citi (subsequently shut down one year after it was taken over) and then offering to manage the company for a salary of $1 smacks of extreme cynicism. The response was that this was legal and above board – and more a mistake made by Mr. Prince the earlier CEO of Citi (who, incidentally, received $138m for his efforts at Citi over 4 years).

This is correct. However, the question I ask is – if something is legal is it necessarily morally acceptable? Should society not expect a higher level of ethical behavior from its leaders – political and corporate? In other words – is there a case for expecting moral absolutism rather than accepting behavior because “others do it too”. If the latter, why should society not make such behavior legal – thereby making it “acceptable”.

The shenanigans of corporate America are too well known to bear repeating. Enron through Madoff, the story continues. What is however, only now attracting comment, is the excesses that corporate America has resorted to – well within the law, but way over the top of what one should classify as acceptable behaviour. John Thain’s $35,000 commode is symptomatic. When the senior executives of the top 3 American car companies went to Congress for a bail-out package, they went by private luxury jets.

If Satyam’s Raju is accused (correctly) if siphoning of large sums of money, the story of Merrill is interesting in that it is legal! In a letter dated Feb 10, 2009, the Office of the Attorney General, State of New York, points out that Merrill, with the apparent complicity of Bank of America, paid out $3.6bn of performance bonus on Dec8, 2008 – well before the due date, and after having lost $15.31bn in the last quarter of the year alone. This necessitated a take-over by Bank of America, and a subsequent bail out by the US tax payer. Does the fact that this is legal make the shareholder’s risk lower? I think not!

It would be well to remember that it is not the case of “poor corporate governance in India” vs “rule of law” in the US. It is simply a case of human greed tilting the scales. At the current moment, it can be safely argued that the level of greed exhibited in the West far outstrips that in other other part of the world – perhaps in human history.

Does this mean that Indian corporate governance standards should not be raised? Or, investors should blindly trust the numbers that companies put out – either in India or anywhere else in the world? The answer, clearly, has to be in the negative. As investors, the cardinal rule has to be “buyer beware”. But this is true as much in India as any other part of the world.

The repeated failures of credit rating companies to predict credit defaults, and audit firms to collude with managements point to the acceptance of moral relativism that has, unfortunately, become a norm in corporate behavior.

John Bogle’s recent book “Enough” (an apt book for current times) quotes Henry Kaufman as saying –

“Trust is the cornerstone of most relationships in life. Financial institutions and markets must rest on a foundation of trust… Unfettered financial entrepreneurship can become excessive and damaging as well – leading to serious abuses and the trampling of basic laws and morals of the financial system. … Only by improving the balance between entrepreneurial innovation and more traditional values can we improve the ratio of benefits to costs in our economic system”

An “us vs them” debate at this stage is futile. We all need to look within to see that we act in a manner that can truly be called “professional”.

Jai Ho!

“Slumdog Millionaire” (SM) has created Oscar history. Those associated with the film have reason to celebrate. I join all in congratulating those whose talent has received recognition at the Academy awards – and wish them greater success.

When the din dies down, it will be worthwhile to examine what we are celebrating. First, this is NOT an Indian film – just one based on a story with and Indian milieu. The song, for which Rahman received the Oscar, is good, but undoubtedly not his best work. I am sure that Anil Kapoor, and to an extent Irfan Khan, cringed when the producer of SM went on stage and stated that when they started the project they had “no money, NO STARS” etc. So, while we share the happiness that winning an award would bring to the awardees, we must carefully look at the lessons learned.

The commercial success of this film internationally is a lesson in great marketing. While our movie stalwarts have tried hard (the leading Khan’s in particular) to “market” their products, the effortless, almost self effacing, ease with which Danny Boyle has “sold” the story is worth emulating. In interview after interview, Boyle comes across as a humble down-to-earth story teller who was so moved by the rags-to-riches story of the protagonist that he achieved “mission impossible”. Danny stresses the positives:

• Universal appeal - the story is of an under-dog who, in the face of adversity, makes a success of life
• The “spirit of Mumbai” – buoyancy and entrepreneurship in the face of abject poverty – is what he seeks to display through this film

But is that really the case? Scene after scene in the movie examines the dark underbelly of Mumbai’s underworld. We are introduced to the “business” of begging and prostitution, to police brutality and drug trafficking. I remember no incident in the movie that illustrates the spirit of striving, of entrepreneurship that Boyle speaks of. The protagonists’ appeal is not in his attempt to achieve more (a la “Satya”), but in a dog-like devotion to a child-hood crush he does not seem to overcome. His participation in the TV show is not motivated by trying to be a success, but a means to reach out to his lost love. And his winning is a function of the brutal life he has led, rather than any active effort on his part. What, in all this, is inspiring?

On the other hand, a recent Indian movie like “Taare zameen par”, has all the ingredients that Doyle speaks of, but are missing in SM. The story of a young lad struggling with a learning disorder is indeed a universal subject. The parental pressure, the child’s emotional response – are both finely crafted and brilliantly performed. None of the actors in SM reached anywhere close to the portrayal achieved by the young actor in Taare. The struggle and eventual success of the protagonist is definitely inspiring. Taare was a success, but not at Hollywood.

What does this tell us about the reasons why some movies make it at the Oscars, and others don’t? And should we care? After all, we are the biggest industry in the world, except in terms of the dollars collected. Judge for yourself.

Power Corrupts...

Maytas's Teja Raju is experiencing a "Deewar" moment - P C Gupta, Minister of Corporate Affairs, has decided that Satyam's Raju's son must suffer because "mera baap chor hai". The Government has decided to dismiss the board and take over the management of Maytas Infra. The reason offered :

"On the basis of information available, the government finds a strong possibility of the affairs of these two companies having been conducted by its current management with fraudulent intent, breach of trust to the stakeholders, and persistent neglect of the obligations and functions."

While it seems reasonable to assume that funds diverted from Satyam would have found its way to Maytas, the question that arises is - in what way is the current board performing its duties to the detriment of its shareholders. If it is, the government needs to explain how. If it is not, it appears that there is an arbitrary exercise of power by the government.

In fact, if the allegation that Maytas received funds owed to the shareholders of Satyam is taken to court, it is probable that the current Board will represent the interest of shareholders of Maytas better than a Government appointed board - that will take its instructions from Mr Gupta. This is the point I was seeking to make in my interview on CNBC on Friday.

The other allegation, made by EAS Sarma in the same interview, - that there was political patronage that helped Maytas in building its business - raised the hackles of Mr. Gulabchand. More so since I pointed out that there cannot be any company involved in the real-estate and infrastructure space that would not have been the beneficiary of political goodwill.

Most systemic clean-ups happen when there is a scam. The financial markets were cleaned up with the setting up of SEBI and the NSE - when the BSE had become dysfunctional and was working for brokers more than investors. One can only hope that the current scam leads to a clean up - not only in the bankruptcy laws of the country - but more importantly, in the clean up of the real estate markets and the appointment of a regulator for the sector. A well functioning real estate market has the potential to unleash huge economic potential while simultaneously bringing a large part of the unaccounted economy above gound.

What's wrong with pledged shares?

Post SEBI's directive requiring "promoters" to declare if the shares they own are pledged, markets are reacting unkindly to the disclosures. The disclosures itself suffer from serious limitations - most arising out of the definition of "promoter" groups. Since many sponsors continue to hold shares in the name of front companies that are not classified as "promoter" companies, it is entirely possible that the disclosures are inadequate at best and misleading at worst.

The more fundamental question, however, arises on whether the market is correct in selling off shares of companies where promoters have pledged shares, or, does this behaviour present a buying opportunity. In my view, the latter.

For the most part, companies in India are still largely owned by a family or by a first generation entrepreneur. Resources for investment are clearly limited. That being the case, if a new investment opportunity were to present itself, what is the man to do other than to pledge assets (in this case the shareholding) and raise funds. Why should that not be viewed as a case of being bullish on the prospects of the investment opportunity?

A possible reaction to this argument would be that this increases the risk in the business, since the equity is essentially debt in disguise. This may well be. However, is it substantially different if the equity of one venture is pledged to raise finances for another - say like in the case of the Tata Group. Isn't this too a case of overleverage, and prone to the same risks? Afterall, most "promoters" do not distinguish between companies that belong to the group - when it comes to crunch time, the cash flows of all companies are used to feed the weak - notwithstanding the presence of minority shareholders that may be and most likely are - different. That this practice is wide spread, and the market is aware of it and tolerates it itself points to the inconsistency of the current response.

An alternate to pledging shares would be that the "promoter" find ways to cheat the minority shareholder of his due share by extracting an unfair proportion of the cash in the business to fund his own investment needs. To me, a pledge is anyday more palatable. So, next time a share price falls sharply because of pledge disclosure, and the business does not look to be in trouble - go BUY.

Overestimating the effects of policy reform?

Mr. Vijay Kelkar, Chairman Finance Commission, recently delivered the convocation address at the Indira Gandhi Institute of Development Research. The speech largely addressed itself to the benefits that a Goods and Services Tax (GST) would bring to the economy. While the benefits of GST need no reiteration(the speech itself makes a cogent case), the figures that Mr. Kelkar puts out seem suspect. He argues that there can be a saving of 1.4% of GDP which translates to $15bn annually. He then proceeds to discount it at 3% to yield an NPV of $500bn.

The question to ask is why use a discount rate of 3%? Unless we argue that the nominal interest rates will average these levels over the next several decades, the case for using such a low interest rate is not clear. In fact, using a 5% rate reduces the implied benefits by more than 50%.

Another area where I find myself skeptical is the contention that more services will get taxed under GST. It appears to me that most services are already being taxed now - banking, telecom, brokerage, consulting etc. Large value services that do not get taxed are largely those that are provided by the government - say the railways. Even these can be viewed as being taxed, since railways are a department of the Central Govt and not a company. It appears that the net addition through taxation of services may not be significant - though I have no estimates, and may therefore be in error.

The downside of GST is often higher prices, lower private consumption. This too is a cost that needs to be kept in mind. As also, the fact that in ensuring that all states agree to the proposals, it is more than likely that GST will not be introduced in the true spirit, and States will continue to impose some form of Octroi or other local taxes. This will again kill the purpose of GST.

In all, the simplicity of the concept itself makes it worth implementing - despite the much lower than projected benefits that may arise.

Caesar's wife should be above suspicion - or perhaps not ?

The story so far - The election commissioner, Mr. Navin Chawla, attracted opposition from 205 members of Parliament when appointed. It was alleged that he could not be non-partisan. The Times of India carried a report:

A Times Now investigation has... found that two trusts floated by Navin Chawla, a member of the Election Commission, received funding of lakhs of rupees under MPLADS from various Congress MPs.

A petition, seeking his removal, addressed to the then President APJ Abdul Kalam, was not acted on. This led to the petitioners approaching the Supreme Court seeking a direction that the petition be forwarded to the CEC. This petition was subsequently withdrawn on the basis of an affidavit filed by the Chief Election Commissioner (CEC) in the Supreme Court. In the affidavit, the CEC claimed that he had authority to, suo moto, recommend the removal of the election commissioner. He quoted the unanimous decision of a Constitution Bench of the Supreme Court of 14th July 1995 (4 SCC 611) where the Judges stated :

That the Election Commissioners could be removed on the recommendation of the Chief Election Commissioner did not make them subordinate to him but only ensured their independence of the political Executive. The Chief Election Commissioner, in any case, could not recommend their removal out of whim or caprice and had to exercise his power with reason and responsibility.

At that time, the Additional Solicitor-General had objected to the statement of the CEC and contended that only the Centre could take action against the election commissioner. The Supreme court reserved judgement on the correctness of the CEC's position. A report on the events is here.

The CEC has, after due process, now recommended the removal of the election commissioner. The government has rejected the recommendation. This now leads to a constitutional impasse. Clearly, this needs to be referred to another Constitution Bench. This goes against the earlier order which seemed to indicate an interpretation favouring the reverse.

At a time like this, when serious efforts need to be made to protect the integrity of the constitutional intent, we have the leading English newspaper in the country worried about the "timing" of the action of the CEC. Ignoring its own coverage, and missing the point of constitutional impropriety - the editorial does not once refer to validity or otherwise of the arguments made by the CEC for the recommendations - the editorial laments the timing of the report in the light of the forthcoming elections.

It seems that a society gets not only the politicians it deserves, but also the newspapers it deserves.