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Morals And Reputation

Mutual funds should ask questions about the corporate governance of the companies they invest in…

SEBI has asked mutual funds to give it details of what they have done to improve corporate governance. This is a follow-up to a circular that SEBI issued in March 2010 that asked all fund companies to formulate guidelines for exercising voting rights that are 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.

There are many reasons for this. For one, even though funds own more stock than do individuals, their holdings are tiny in comparison to promoters and other institutions. But even this is probably not the real reason. There’s a theory that funds simply shouldn’t ask questions about ethical issues. Instead, they should just ‘vote with their feet’.

Over the last two decades, the institutionalisation of investing has certainly helped improve the standards of governance. However, this has been due more to indirect rather than direct action. The idea has been that funds (and other institutions) will invest only if governance standards are good, and if these decline then they’ll sell and move out, presumably driving down the stock price.

In this context, I’d like to quote something very interesting, written by an American author named Bruce Schneier. “In any system of cooperative behaviour, an uncooperative strategy will be effective — and the system will tolerate the uncooperatives — as long as they’re not too numerous or too effective. Thus, as a species evolves cooperative behaviour, it also evolves a dishonest minority that takes advantage of the honest majority … Humans evolved along this path. The basic mechanism can be modelled simply. It is in our collective group interest for everyone to cooperate. It is in any given individual’s short-term self-interest not to cooperate: to defect, in game theory terms. But if everyone defects, society falls apart. To ensure widespread cooperation and minimal defection, we collectively implement a variety of societal security systems. Two of these systems evolved in prehistory: morals and reputation.”

Morals and reputation. Those are the key words. Schneier sums up the problem perfectly. Unless there is a functioning system that links reputation with behaviour, the dishonest minority will gradually gain the upper hand. This will eventually lead to a general reduction of trust and will eventually damage everyone’s prospects—even the honest companies and the sincere investors. Most of us recognise that in India we are getting closer to this point.

Therefore, as high profile components of the investment eco-system, funds need to go beyond just voting with their feet. If a company’s business looks fine and yet there are corporate governance issues, then AMCs need to raise their voice. There’s no point whining that the system is like that and one investor’s question won’t change anything much.

Corporate governance is a balance between opposing pressures. Just the prospect of a high profile investor asking tough questions can shift the balance a bit. Enough such questions and the balance can shift enough to make a difference to investors.