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.