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Light on Corporate Cross-funding

For investors, a company's cross-funding in its business group can be either an advantage or a disadvantage...

The misadventures of the Satyam Computer Services Chairman Ramalinga Raju and his board of directors has suddenly brought into focus what is generally called corporate governance. A few days ago there were some newspaper reports of what looked like another corporate governance issue, this one from the Chennai-based Muruguppa group. It seems that the group's finance company, DBS Chola Finance (which is co-promoted by the Development Bank of Singapore), was being helped out using cash from listed group companies like EID Parry, Tube Investments, Carborundum Universal and Coromandel Fertilizers. The group companies are to subscribe to preference shares that will be converted to equity later.

Apparently, some institutional investors don't like this and see it as a variant of what Raju tried at Satyam. However, as one news report pointed out, what is happening with DBS Chola happens in most Indian business groups. This is not seen as unethical or an undesirable practice. In fact, this sort of a thing is exactly what defines a 'business group' in the sense that the term is used in India.

When money is needed for a new or struggling business, then the other group companies invest in that business. There are variations to the theme such as the role played by holding companies, but the basic idea remains that of cross-funding within a business group. The general line that critics take is that 'if investors wanted to invest in the new business, then they would bought shares in some other company that already does that business.' By itself, in intellectual isolation, this is a neat and satisfying argument that appears to be unanswerable.

However, I believe there's measure of hypocrisy built into this view. Given the economic history of India, many large businesses could not have come into existence without such cross-funding. Investors buy a companies' shares in full knowledge of its membership of a business group and this plays a role in their decision to buy into a company. As indeed, it does of consumers buying a company's products. If you remember what the first Indica was like, you should wonder how many people would have given that line of cars a second chance had it not been a Tata product. An investor who is buying a stock for anything more than a year or so is as much taking a call on the promoters and managers of the company as much as the details of its business.

Does this justify what Raju tried to do and many other promoters successfully do? Not at all. There is considerable pilferage of shareholders' wealth in India. Many promoters always think of themselves as the owners and other shareholders as merely a source of financing. By instinct, they never consider shareholders to be co-owners. But the Raju affair is not even this-it is far worse. As recent revelations have shown, the Rajus were no longer the promoters-they had gambled away almost all their stake in Satyam. They just took advantage the situation. They had a hand-picked board full of their cronies so they tried to grab a few thousand crore rupees to give themselves a fresh start in life as business-owners.

For investors, a company's part in a given business group could be an advantage or a disadvantage. At the very least, it's a useful information point. In the hard times that are coming, both the pros and cons will show up sharply.