The Changing Face Of Shareholders: Outsourced Governance

Institutional investors can’t outsource their governance obligations to proxy advisory firms. They must take responsibility.

Pedestrians cast shadows as they walk through the City of London, U.K. (Photographer: Luke MacGregor/Bloomberg)  
Pedestrians cast shadows as they walk through the City of London, U.K. (Photographer: Luke MacGregor/Bloomberg)  

The corporate governance discourse in India has been dominated by concerns surrounding concentration of ownership and promoter control in companies. As a result, protection of minority shareholders has taken centre stage. But, recent events have triggered an altogether different discussion that commonly occurs in Western markets, namely the role of institutional investors who are guided by an active band of proxy advisors with the potential to destabilise management.

The Changing Face Of Shareholders: Outsourced Governance

Housing Development Finance Corporation Ltd. Chairman Deepak Parekh narrowly retained his position as a non-executive director as two U.S. proxy advisory firms ISS and Glass Lewis recommended that institutional investors vote against the resolution for extension of his appointment beyond October 2019. While ISS’ concern was that he was on more than six public company boards and hence a busy director prone to “over-boarding”, Glass Lewis felt that HDFC’s board is not independent enough. This has brought about considerable consternation among the managements of Indian companies, including a clamour for subjecting international proxy advisory firms to Indian regulations. The episode reveals two phenomena: first, the changing face of shareholder composition in Indian listed companies, including the increasing significance of foreign institutional investors and, second, the enhanced role of the U.S. proxy advisory firms in influencing corporate decision-making in Indian companies.

While the shareholding in Indian companies on average continues to be concentrated, the holdings of several large listed companies have become dispersed. They are devoid of promoters. Well-known examples, apart from HDFC, include ICICI Bank Ltd. and Larsen & Toubro Ltd. Moreover, as in several other jurisdictions, foreign institutional ownership is on the rise in India.

For example, foreign portfolio investors hold in excess of 72 percent in HDFC. This allows outside shareholders to exert pressure on management.
Deepak Parekh, chairman of HDFC Ltd., speaks during a Bloomberg event in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)
Deepak Parekh, chairman of HDFC Ltd., speaks during a Bloomberg event in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

Even in companies with concentrated shareholding, a similar scenario may arise on specific issues. The law on related party transactions requires a ‘majority of the minority’ voting in approving material transactions wherein the promoters are deprived of voting rights on that decision. Here again, outside shareholders such as foreign institutions may wield considerable influence – that too in promoter-owned companies. Such a paradigm shift in share ownership patterns, at least in large listed companies, alters the rules of the governance game.

The HDFC episode has touched a raw nerve – the leverage that U.S. proxy advisors have over the governance of Indian companies. The proxy advisory industry is not novel in India as three firms have established themselves in the country since 2010 and have been active in issuing recommendations to institutional and retail shareholders on corporate voting matters.

While the Indian advisory firms are subject to registration with the Securities and Exchange Board of India under its regulations issued in 2014 to research analysts, the U.S. ones are not.

Company managements have raised alarm bells that U.S. proxy advisory firms, therefore, resort to a ‘hit and run’ strategy and that they do not possess sufficient understanding of the Indian markets and the nuances of specific Indian companies and their board structures.

The U.S. proxy advisory firms have enabled foreign institutional investors to take on a more active role in the governance of their portfolio companies. Given that several of these institutional investors are intermediary investment entities that owe duties to their ultimate investors, they tend to outsource their governance decisions to their proxy advisory firms. While institutional investors are entitled to seek the advice of the proxy firms on governance matters, as it would be costly for them to undertake these functions internally, problems arise when the investors simply go by the proxy firms’ recommendations without an independent application of mind.

When a large number of institutional investors repose almost blind faith in their recommendations, the proxy firms’ influence on the governance of portfolio companies stands magnified.

This necessitates a closer scrutiny of the process and performance of the U.S. proxy advisory firms in the Indian context. A number of considerations come to the fore.

First, the U.S. proxy advisory firms operate in a duopolistic scenario.

Reports estimate that ISS and Glass Lewis enjoy a 97 percent market share between them.

The lack of competition and high barriers to entry means that the reputational incentives of such market intermediaries may not be fully realisable. Similar situations arose in the past with credit rating agencies and their roles during the global financial crisis.

Second, concerns surround the manner in which the proxy advisory firms conduct their research and issue recommendations. Arguably, the methodologies and metrics they develop are too general and fail to highlight the specific issues involved either in a country or in a company.

Firms are prone to gravitating towards a set of ‘check-the-box’ or ‘one-size-fits-all’ metrics. 

Although proxy firms seek to instill standards that are above and beyond those prescribed by law, an excessive level of standardisation in the approach could be counterproductive.

Take the case of ISS; it issued the ‘India Proxy Voting Guidelines: Benchmark Policy Recommendations’, which generally recommends voting against the appointment of a director if the “nominee sits on more than six public company boards”. This pays no regard to the profiles of the individuals, their contributions to the company, or their ability to juggle various roles effectively, for instance, by ensuring their active attendance at meetings of all boards on which they sit. The current approach engenders homogenisation when there is a need for customisation.

The third aspect relates to the regulatory oversight of proxy advisory firms. While the industry has largely been unregulated, several countries have sought to impose registration requirements. In the U.S., the Corporate Governance Reform and Transparency Act has been passed by the House and is being considered by the Senate. This would require proxy advisory firms to register with the U.S. Securities and Exchange Commission. In India too, there have been calls to rectify an anomaly by which Securities and Exchange Board of India’s regulations do not extend to the U.S. proxy advisory firms.

However, regulation is likely to address specific issues such as conflict of interest, but may not encompass matters concerning the accuracy of the proxy advisory recommendations.

Moreover, the Indian model of regulating the proxy advisory industry as an offshoot of the research analyst community brings with it an entirely different set of oddities.

Finally, the answer may lie in a market-based approach that places the burden on the consumers of the proxy advisory firms, namely the institutional investors. The consumers of governance recommendations must be discerning in their analysis and acceptability.

No longer can they simply outsource their governance obligations; they must take responsibility for individual voting decisions based on the advice received.

They must adopt a stewardship role by which they enhance value for their own investors on the one hand and improve the governance of their portfolio companies on the other. Several securities regulators around the world, including in Asia, have published stewardship codes that provide a principles-based framework for institutional shareholders to discharge their governance functions more effectively. Given the increasing influence of institutional investors in the Indian markets, the need for a stewardship code has never been stronger.

Umakanth Varottil is an Associate Professor of Law at the National University of Singapore. He specialises in company law, corporate governance and mergers and acquisitions.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.