Can laws mandating dispersed shareholding counter entrenched inequality in India?

Addressing entrenched inequality is a pressing matter in India. It appears to acquire special urgency every five years, when a general election beckons. If 2013 saw the enactment of a mandatory spending CSR law, the current government is now contemplating the reintroduction of an inheritance tax on property, that Prime Minister Rajiv Gandhi had abolished in 1985. Dr Kaushik Basu (former chief economist to the Indian government and chief economist at the World Bank) has also recently mooted a radical reform, whereby ‘anti-monopoly laws shall be replaced with legislation mandating a wider dispersal of shareholding within each company’. According to this formulation, the traditional competition model is to be scrapped. In its place, firms would enjoy monopolies over specific processes in the chain of production. This would allow economies of scale, increase overall efficiency of firms by preventing the wastage of resources inherent to competitive markets, and thereby maximize corporate profits. Further, the proposal argues that such profits, provided they are appropriately distributed, could help reduce inequalities. For that purpose, the shares of each company need to be widely held by the public: corporate profits would thereby effectively pass on to a large basis of shareholders. The proposal therefore recommends legislation mandating a wide dispersal of shareholding in Indian companies, which have traditionally seen their shareholding concentrated in the hands of one dominant business family or ‘promoter’.

However, this proposal faces various challenges. First, policymakers have ignored evidence from corporate governance, highlighting that widely-held freestanding firms do not efficiently pass on corporate profits to their shareholders. Instead, they come with their own set of problems, which may offset any gains in efficiency and attenuate shareholder access to corporate wealth. Second, mandatory dispersal of shareholding would require a radical recasting of India’s corporate law, and such reconceptualization would have to be presaged by an equally radical political change, which appears difficult to achieve in India’s present political economy.

Problems of widely held firms and benefits of concentrated shareholding

A fundamental assumption in corporate governance studies is the ‘Berle and Means assumption’. After sampling the largest 200 firms in the United States, Berle and Means concluded that 44% of the firms were: (a) widely held—their ownership was dispersed across a large number of small public shareholders; and (b) freestanding—not owned by other companies in a pyramidal structure. Based on this observation, corporate governance scholars have relied on two flawed assumptions: that all firms are widely held, hence that all firms have a separation of ownership and control. Because the owners of such firms (small, dispersed shareholders) have very different economic incentives from the managers, this strand of scholarship focused on the agency costs arising from the separation of ownership and control. Such scholars argued that that the principal aim of corporate governance research should be to bridge the divergent interests of management and ownership in widely held firms. For such scholars, small shareholders in widely-held companies are indeed unable to single-handedly check management and ensure distribution of wealth, unless they effectively form coalitions. However, such activism is difficult to generate and sustain, and easy to counter. Consequently, companies that are not widely held and have one or two large shareholders with concentrated shareholding would be better able to discipline managers.

However, in 1999, the Berle and Means assumption was challenged by the pioneering work of La Porta, Rafael, Lopez-di-Silanes, Shliefer and Vishny. They established that in most countries, concentrated shareholding (often in the hands of wealthy business families) were commonplace; the Berle and Means assumption was therefore only valid for the US and the UK. Subsequent studies confirmed the La Porta rule for East Asian countries, Western Europe and India.

Corporate governance studies, carried out following the La Porta finding, show that although concentrated shareholding structures can lead to large agency costs, they also bestow tangible benefits: (a) they can create economies of scale as business families think over multiple generations; (b) they can create internal capital markets; (c) they fare better at political rent-seeking as their commitments can be multi-generational; (d) they can rely on informal, inter-familial networks to enforce promises in unreliable legal systems; and (e) they can outperform widely held firms. Some scholars therefore see family-owned corporations as segways into first world industries for national economies that are underdeveloped, or institutionally handicapped. Breaking up concentrated shareholding structures (by measures such as inheritance taxation and easing hostile takeover norms) would imply sacrificing these benefits.

Since widely held firms generate agency costs, such firms may not effectively redistribute corporate wealth to their shareholders. Meanwhile, mandating a dispersal of concentrated shareholdings could blunt the tangible advantage such shareholding structures confer. Therefore, a law mandating wider dispersal of shareholding is unlikely to be a silver bullet for the problem of entrenched inequality.

India’s political economy may not allow for such a radical change

Extant corporate law would also have to be radically reconceptualised for widely held firms to serve as a means of wealth distribution. Scholars have long battled over the appropriate role of corporations. For the most part, corporate law is concerned with maximizing share value. However, Dr Basu’s proposal is based on a social entity view of public corporations, which holds that corporations are tinged with a public purpose that they must fulfil. Such a proposal would require reconceptualising two centuries of corporate law which has viewed corporations solely as a means of wealth generation for its shareholders, and which continues to influence vast tracts of existing corporate statutes. Any such reconceptualization, however, would only be possible through a radical upending of India’s political economy.

When India liberalized its economy in 1992, the government enacted a new takeover law with the ostensible purpose of creating a genuine market for corporate control. In reality though, the law did exactly the opposite: it allowed Indian business families to consolidate control over their companies by making hostile takeovers difficult and by creating carve-outs for certain control transactions. Business families capitalized on this and registered a dramatic increase of their shareholdings. The average shareholding of promoter-families jumped to 49.14% by 2006 and had further increased to 54.21% by 2011. Therefore, even at the height of India’s most radical economic reforms, there existed bipartisan support for preserving India’s business-family model.  Any legislation to force a wider dispersal in shareholding will invite stringent opposition, not just from business-families which stand to lose control, but also from India’s policy elite which views business-families as national champions. Easily the biggest hurdle to a recasting of Indian corporate law will come from the powerful State-business nexus that is now a permanent feature of India’s polity.

Jeet H. Shroff (LL.M. Harvard) is a Mumbai-based lawyer.