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Divestment and governance

Subir Gokarn

The controversy over the Tatas' decision to invest Rs 12 billion of VSNL's funds in their basic service provider, Tata Tele Services, raises a number of issues relating to the management and governance of privatised enterprises.

Regardless of the outcome in this particular case, the positions taken by various players, particularly the government, will inevitably have an impact on future attempts by the acquirers of public enterprises to implement their business strategies.

The controversy raises two critical questions. Will the government insist on playing an active role in defining the boundaries that the acquirers have to operate within? And, what mechanism will it use to assert its positions?

Looking back on the VSNL episode, there are a number of pointers to the government's preferences and the instruments that it is willing to use to realise them. There are three aspects to the case, which are of particular interest.

The first is the legitimacy of the decision made by the new management to invest the funds in a basic service provider promoted by them. The second is legitimacy, or at least wisdom of the government's reaction to the decision. The third is the possible failure of the process by which the government's interests as a shareholder were represented and protected.

I have no particular capability to comment on the legal aspects of the situation, but there are some clear economic dimensions to each of these aspects. The principle that addresses the first issue is: you get what you pay for. This applies to an enterprise as much as it does to a kilogram of fruit.

There is a clear understanding, or at least there should be, about the ownership and control of the newly divested enterprise, and this is formalised in the shareholders' agreement.

The government did have the opportunity to extricate surplus funds from VSNL before the sell-off. It did this to an extent by declaring a special dividend, of which, being the largest shareholder, it was the biggest beneficiary. It could just as well have taken away the remaining money, in which case, the controversy would not have erupted. But, this would have affected the valuation proportionately.

Having been paid what it asked for (in terms of a reservation price) the government must adhere to the principle of getting what you pay for.

The investment strategy of the company is now made the same way in which any public limited company makes these decisions; a set of proposals are made to the board of directors and they are either approved or rejected.

Board members represent both the interests of the shareholders at large and the interests of specific groups of shareholders, who may have objectives in addition to maximising the value of their investment.

Corporate governance is essentially a set of incentives and instruments, which bring the interests of the management and shareholders into reasonable alignment with each other. Decisions affecting the welfare of shareholders are best made within the scope of these incentives and instruments.

To take them outside this realm, unless there are some concrete policy issues involved, is to deny the shareholders the value of this control mechanism.

The only legitimate role for the government in this scenario is that of a shareholder. Whether the government continues to hold an equity stake in the companies it privatises is a policy issue.

Once that decision is taken, the government, as a shareholder, should obviously be eligible for all the protections and rights that company laws provide any shareholder.

In this capacity, the economic logic of the investment decision can surely be questioned and the proposal rejected if it does not seem to further the interests of the government or any other shareholder.

What are the economics of the investment? There are clearly pros and cons.

On the positive side, the funds are being invested in an upstream entity, which has a clear place in the Tatas' stated intention of building themselves up as an integrated telecom services provider.

Straddling the entire chain from local services to national long distance to international services is a perfectly legitimate strategy in telecom, justified by both the technological conditions of the sector and the alternatives available for pricing of services.

The investment is clearly consistent with the announced strategy and should therefore have come as a surprise to nobody. The negative side of the equation is the valuation that the proposal puts on a basic service provider, which is yet to cross any reasonable threshold of subscriptions.

The point is that these considerations would be the natural basis of a board decision, which would reflect the government's concerns to the extent of its financial interest in the company.

This brings into focus the third important aspect of the case. Were the government's legitimate concerns as a shareholder adequately represented?

One of the government's nominee directors, who apparently endorsed the decision when it was taken, later claimed that the information provided to him was inadequate, both in terms of content and timeliness. If this is indeed the case, then, clearly, the instruments of corporate governance failed.

This could be construed as manipulation, but I believe that there is a deeper historical underpinning to the ineffectiveness of government nominee directors.

The long and the short of it is that government nominees are on these boards because they happen to be occupying a particular position in the parent ministry. Given the job mobility of senior civil servants, can one seriously expect them to develop the specialist knowledge about business strategy and corporate governance that an effective board member would be required to have?

Some individuals might do it, but there is nothing in the system that fosters this and there is also nothing in the system that ensures that the most appropriate person occupies the position. Any governance system that depends on luck is bound to fail.

Whatever the circumstances of the government nominee's role in this instance, it does raise a very fundamental question. Are the government's interests as a shareholder going to be better served by professional directors than by incumbent bureaucrats? In my view, this is the fundamental change that the controversy presages. If business decisions are to be taken, they must be taken by business professionals.

A bureaucrat seeking to be a member of a corporate board must prove that he has the necessary credentials. Just because he happens to be in a particular ministry at the time is not good enough reason.

In short, my answers to the two questions I started off with are: the government best serves the interests of the enterprise by acting as a vigilant and diligent shareholder. The realms of policy and strategy must be kept separate and distinct.

And, its interests as a shareholder are best protected by having them represented by professional directors. Bureaucrats are best kept out of the boardroom and in the secretariat.

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