Fall from grace

Companies should provide for buyback to compensate the wealth erosion due to fraud 

or negligence

By Mohan Sule

The fall from grace of Volkswagen should be a wake-up call for companies, regulators and investors. The German auto maker is paying nearly US$15 billion to settle claims in the US that it cheated on emission norms of some diesel vehicles. The figure represents about 25% of its current market value that plummeted more than 40% to a four-year low in the three days since the US environmental protection agency slapped a notice in September 2015.It will be spending nearly US$18 billion to rectify the fault.  World’s largest furniture maker Ikea is recalling 35 million chest of drawers and dressers found to trip and crush toddlers. Besides covert or overt negligence, accidents also result in huge outgo. When oil gushed for 87 days in the Gulf of Mexico following an explosion and sinking of the Deepwater Horizon rig in April 2010, the civil and criminal settlements cost BP US$42 billion in the next three years besides the US$18- billion fine two years later in the largest corporate settlement in the US till then. The other source of trouble is outsourcing.  Apple had to intervene when a large number of suicides of workers were reported at its supplier’s facility in China due to rigorous working conditions. In the meantime, there were calls from consumer activists to boycott its products. The crux is if companies test the boundaries of ethical behavior knowingly to cut costs by deploying substandard technology and materials. The second issue is the response. The quick action of recalling Tylenol , contributing nearly 30% to its profit in 1982, by US healthcare player  Johnson and Johnson after a renegade’s tampering spree has now become a case study of how a company should act in times of panic.

Contrast this with what has happened in India. When worms were found in its chocolates on the eve of Diwali 2003, Cadbury blamed the dealer in Pune for not storing the products in the requisite environment. Later, it roped in Amitabh Bachchan, no doubt at a fat endorsement fee, to assure buyers but did not recall the chocolates. The good thing that came out was that the MNC had to spend Rs 15 crore on machinery to make products foolproof, insulating shareholders from such nasty shocks going ahead. The recall of Maggi noodles on finding high quantity of MSG after a lab in Uttar Pradesh and in Kolkata found lead in June 2015 appeared a forced decision after the Food Safety and Standards Authority of India banned the product. Indian consumers are yet to read about any brand of bread being withdrawn from the shelf after discovery of cancer-causing chemicals in some batches. Indian pharmaceutical makers are frequently in the news for some sort of strictures or alerts issued by the US FDA on their processes and facilities. The stock dips on such incidents but bounces back subsequently on the strength of penetration of the market and other items in the bouquet. Nestle, too, lost value as Maggi contributed nearly 30% to the bottom line but recovered partially on the back of sustainable demand for other legacy products. 

In fact, the trajectory sums up the dilemma of Indian investors when faced with situations of stocks in their portfolios facing unexpected crises. The immediate reaction is to head for the exit. Some vulture investors see the beaten-down counter as an opportunity in the belief that not all parts are rotten or the distressed asset might be a takeover target. Sometimes they are proved right as in the case of Nestle and Satyam Computer Services. The recurring qualifications of auditors of several companies refer to inadequate or nil provisions for contingent liabilities. These encompass payments choked due to the sickness of clients, projects stuck in distant lands due to war or civil unrest, litigation with land owners and income tax disputes. Many do undertake write-offs but an existential crisis can have the might to erode the net worth. Surprisingly, companies spend huge amounts on fire-fighting but do not offer a buyback to shield the minority shareholders from the repercussions. Therefore, why not mandate those with Rs 1000-crore sales to keep aside 2-3% of their profit just as they have to use 2% to fulfill their corporate social responsibility obligation? Investors feel helpless if companies to which they had taken exposure in good faith tumble due to fraud. At such time, the protection fund should be used to mop up non-promoter shareholding at a pre-determined price to compensate the wealth erosion due to any promoter-driven scandal. In the event of accumulation, the cash should be handed back to the ordinary shareholders every moving fifth year as special dividend. Besides providing a safety net to the small shareholders from acts of omission and commission of companies, the move will enhance the credibility of promoters.  

The limits of groups

Looking at the meltdown of the USSR and the chaotic federal structure of India, a common European market was impractical

By Mohan Sule

Now that the referendum to decide Britain’s exit from the European Union is done with, it is time to focus on the core issue. Do groupings serve any purpose? Have they outlived their objective? Should such forums be disbanded? The euro region is not the first of such associations. Earlier, countries with similar ideologies came together for defence and offence. This was the post World War II period, when there were two camps defined by their economic models. It was capitalism versus communism. Yet, the North Atlantic Treaty Organization did not have free trade among its members. Though the aim of the Warsaw Pact was to counter the US-led line-up of allies, it also worked as an informal common platform comprising satellites of the Soviet Union. So here was a paradoxical situation of a socialist bloc having a unified market but a bunch of free-market economies imposing tariff barriers for intra-trade. Eventually, nations began signing bi-lateral pacts for favorable export-import terms. Two-nation agreements subsequently expanded to include nations in the same region. The US signed the North America Free Trade Agreement with Canada and Mexico. African, Caribbean and Pacific group states formed ACP. Further up the value chain was the bunching of countries with shared characteristics and goals, leading to configurations such as G-5, G-8 and G-20 comprising rich countries and those with huge markets. In fact, a clever market analyst devised the acronym Brics to club emerging economies on the threshold of rapid growth.

The disintegration of the USSR should have alarmed those who propounded and backed the idea of euro. Unlike G members, cooperation based on geography rarely succeeds. First, being neighbors does not necessarily mean that countries share common goals and values. The South Asian Association for Regional Cooperation remained a non-starter for many years due to Pakistan’s reluctance to grant transit rights and concessional tariffs to India. Second, the strong members, invariably, have to bear the burden of carrying with them weaker countries. European communist countries were provided cheap oil by Big Brother. Germany was the biggest contributor to the bail-out of Greece and absorbing refugees from Syria. Third, a common currency compounds rather than eases the problem. Struggling nations need a weak currency to boost exports. Its value, however, can be influenced by members who are doing well. Fourth, despite proximity, cultures of nations might differ. Germany and France were on the opposite side during the war. Absence of a common language to bind the members as in the case of the euro region, where English, German, French and Spanish are spoken, often results in the eruption of parochialism. Fifth, a central bank sets interest rates and controls the availability of money, but risk-taking among countries differs as is evident from the bankruptcy of many smaller countries. The problems faced by federal entities such as India due to lopsided development of different states with governments not necessarily of the political party ruling at the Centre should have served as a cautionary tale. Till recently, inter-state passage of goods was ruled by different entry tax rates. Some states’ focus is on prohibition, others on giveaways.

Yet, weaknesses can also be strengths. Poorly governed states such as Bihar, Uttar Pradesh and West Bengal are pulling down the overall GDP growth of India. They also symbolize the enormous potential of the Indian market were they to undertake reforms. Due to their low base, the country’s economic growth has the capacity to remain in double digits for the next decade. The problem with the euro region was that due to the protection of a common currency, there was no initiative for weaker nations to boost growth. What are the lessons for investors? Mutual funds are supposed to be the best demonstration of collective power. Private placement and a say in book building enable them to demand finer prices. But expenses such as churning costs, asset management fees and distribution commission eat into profit. Returns of most are barely above secure and staid fixed-income instruments. Most big-ticket investors are interested in capital appreciation rather than bothering about corporate governance practices. Their exits and entries are touted by internet investment gurus without explaining the rationale for the action. With the experience of the difficulties facing the euro region and of regional power satraps carving out their fiefdoms, the wisdom of divided we thrive seems to be a better analogy for the present times.