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Can't Vote With Their Feet

Investors need to give the impression that they're watching to get corporate governance to improve…

Last week, markets regulator SEBI asked mutual funds for details of what they have done to improve corporate governance. This is a follow-up to a circular issued in March 2010 that asked all AMCs to formulate guidelines for exercising voting rights held by them by virtue of their stock ownership. At first glance it seems that mutual funds can add an important voice to that asks questions about corporate governance standards of companies where they have invested. However, as far as I know, this has never happened on any scale. In practice, funds are passive shareholders who don’t believe in asking uncomfortable questions.

Certainly, in response to SEBI’s action, AMCs have formulated policies on the way the will exercise their votes and some of them have even put them up on their websites. But as one would expect, these have the flavour of mission or vision statements that companies like to have. While they do have the obvious bromides about high standards and investor interest, they actually contain little that could possibly set the pigeons aflutter in the boardroom of any company that actually has governance issues.

This is true not just of mutual funds, but of all other similar classes of investors like insurance companies and even FIIs. The reason is that financial investors believe in ‘voting with their feet’. The meaning of this vivid phrase is that if they find that there is something questionable with the way a company is being run, then they will simply sell and walk away. And if enough shareholders do this then the stock price will fall and the same affect would have been achieved.

In terms of practical behaviour, this boils down to investors never saying a word about any problems they see. This is unlikely to change.You see, all shareholders are, in a manner of speaking, in competition against each other. Imagine you own a chunk of stock in a company and you realise, before anyone else does, that there are serious governance or ethical issues afoot. What would you do? Would you wait for the next AGM and raise those issues? Of course not, you’d be a fool to do so because when those problems become public, other shareholders might start voting with their feet before you do. Such behaviour is not incidental to stock investing, having an information advantage over everyone else is what stock investing is all about. It is illogical to assume that any shareholder will voluntarily surrender such an advantage in order to achieve the greater good of all shareholders. That’s not the way this game is played.

Therefore, the logical course of action for any shareholder in such a situation is to sell the stock quietly and sneak out of the side door before the general rush begins. We actually saw this in the case of Satyam Computer when some FIIs were reported to have started selling at the first sign of trouble, even before Raju’s fateful letter. In the case of mutual funds and hedge funds the competition with each other is even more direct—in all probability, each would actively want the other to be misled and get lower returns.

However, just because this is the logical thing to do does not mean that it’s the right thing. The institutionalisation of investing over the last two decades has been a driver of improved governance. Eventually, some promoters do get worried about what investors think and whether that will affect their ability to raise money eventually. Corporate governance is a balance between opposing pressures. Just the prospect of a high profile investor asking questions can shift the balance a bit. As long as there’s a general impression that investors are watching and can ask questions can affect the behaviour of at least some managements. Enough such questions and the balance can shift enough to make a difference to investors.