Capital Structure of Indian Family-owned Companies: A Theoretical and Contemporary Perspective
– Param Pandya*
This article discusses the theoretical foundations of how family-owned companies procure finances and how they apply to Indian family-owned companies. Delving briefly into the macro picture of Indian family-owned companies, this article draws attention to the promoter-induced fraud-fraught Indian banking system. It also discusses the mixed regulatory reactions which have attempted to address the corporate governance malfunctions in family-owned companies. This article concludes by stressing on the need to tailor-make regulations aimed at bringing enhanced transparency in financing practices of family-owned companies.
Companies require finance for various short term or long-term purposes such as meeting recurring expenditure or for expansion and growth. While accumulated profit is an internal source of finance, borrowing from banks, financial institutions and bond market constitute the external sources of finance for a company. A company can also choose to issue equity to meet its funding requirements.
Due to adverse selection, a company prefers retained earnings to debt, and only in extreme circumstances resorts to equity for meeting its financing requirements. This premise, in corporate finance literature, is widely known as the pecking order theory. However, as per the trade-off theory, the company looks for a leverage ratio where they can take maximum benefit of the tax shield from debt, while also avoiding financial distress.
When analyzing corporate ownership structure, corporate law scholars have typically assessed the presence of a controlling shareholder as a source (or symptom) of bad corporate governance and a result of bad corporate law. This premise is based on the understanding that controlling shareholders may extract ‘private benefits of control’– for example, by entering into related party transactions, using company’s funds for personal use or funding pet projects – at the cost of the minority shareholders. Despite this general presumption, literature suggests that companies with concentrated ownership, either by family or state, are successful. In fact, concentrated shareholding patterns are the most common form of distribution of corporate ownership outside the United States and United Kingdom, and are particularly common throughout continental Europe, Asia and Latin America. In Asian economies, including India, concentrated ownership and control is the rule rather than the exception.
While the definition of family ownership varies across literature, it is understood as a form of concentrated ownership which consists of companies run by heirs of the founder or by families that are clearly in the process of transferring control to heirs. Companies with family ownership have distinct corporate governance concerns. For instance, the traditional agency problem between owners and managers appears to reduce in family-owned companies as there is largely an alignment of interest between the founder family and the senior management. However, the agency problem between majority shareholders and minority shareholders, and between creditors and majority shareholders is heightened in family-owned companies. Family feuds and lack of succession planning also affect the governance of family-owned companies.
Certain corporate finance experts have also studied the relationship between family ownership and capital structure of companies. One view, known as the efficiency-based theory, considers family ownership as a source of comparative advantage because of family owners’ long termism and relational capital. This theory puts in a good light, the proximity between family and lending institutions. However, the cultural theory opines that the family firms’ conservatism, lack of competency, and agency-conflicts may significantly reduce firm value. Thereby, lenders negatively evaluate family control and are averse to lending capital to family firms.
Since founder families are not inclined to dilute their control over the companies, they prefer to resort to debt financing- and in order to avoid cost of debt they prefer internal accruals to debt financing. Thus, financing decisions in most family firms follow the pecking order – internal accruals, debt and then equity. Since the founding family has more ‘skin in the game’, they either mortgage their personal property (including pledging their equity) or property of associate companies of which they are the principal shareholder-managers as collateral security, or stand as guarantor for repayment of loan. This aspect plays an important role in reducing the overall agency cost of debt similar to how provision for collateral security reduces cost of finance as well as cost of monitoring. However, despite providing collateral, agency problems continue to persist due to misalignment of interests in certain cases (for instance, when founder/founder-family extracts private benefits of control) between controlling shareholders and debt holders.
A Contemporary Indian Viewpoint
Indian companies have been characterized by the pervasive control of founding families. The Indian nomenclature of family-owned companies is typically characterised by the control of the ‘promoter and the promoter group’. A 2018 study by Credit Suisse on 1,000 family owned companies found that India (108 companies) ranks third in terms of number of family-owned companies – the rankings being led by China (167 companies) and then the United States of America (121 companies).
There is no doubt that Indian family-owned companies have made noteworthy contribution to the growth and development of the Indian economy. However, it will not be incorrect to state that family-owned companies have been subject of major frauds. The Satyam Scam (2009) often referred to as India’s Enron, was perpetuated by the company’s founder and some of his family members in connivance with the auditors of the company. Vijay Mallya, an industrial tycoon, has also been alleged to have siphoned off funds lent to his group companies by many banks and has fled to United Kingdom to escape arrest by Indian law enforcement agencies. Nirav Modi, a diamond merchant and Mehul Choksi (a relative of Nirav Modi) both have fled India to escape charges pertaining to fraud. Their companies had fraudulently obtained finance from banks and these funds were diverted for other purposes. Recently, certain banks have discovered the fraud committed by the Neeraj Singal, promoter of Bhushan Power & Steel. The Central Vigilance Commission (CVC), India’s apex anti-corruption agency, studied 100 bank frauds (as on March 31, 2017) across 13 different sectors of the Indian economy. Based on a reading of the CVC Report, it can be assessed that in frauds pertaining to 6 out of 13 sectors, promoters had siphoned off funds which were fraudulently obtained from banks through different modus operandi. These instances clearly depict that lack of effective institutional and regulatory checks and balances may provide perverse incentives to founders/ founder’s family to extract ‘private benefits of control’ at the cost of creditors and minority shareholders.
In the Indian scenario, promoters have developed relationships with lenders and politicians, which allowed them easy access to finance. These relationships have, in certain cases, aided companies to borrow funds as a favour. For instance, there are serious allegations against the CEO of a prominent private sector lender for procedural impropriety and conflict of interest in providing a loan to the Videocon group – since the husband of the CEO and the promoter of the Videocon group were business partners. In another instance, the promoter of CG Power retained the position of Chairman despite having lost majority shareholding as lenders had invoked the pledged shares. Recently, CG Power has admitted to multiple violations including understatement of liabilities, net worth, loans to related and unrelated entities and use of its assets to obtain loans. Now when such allegations of a fraud have surfaced, lenders are demanding the removal of the promoter as Chairman. Thus, apart from non-dilution of control – ease in obtaining finance due to existing relationships with banks, financial institutions and politicians is also one of major reasons why Indian family-owned companies prefer private debt.
Interestingly, certain authors have argued that whether a country is bank-oriented or market-oriented depends on the ownership structure of the corporate firms in that country. In countries where companies depict concentrated ownership, particularly dominated by family ownership, dependence of companies on banking system is much more pronounced, as is the case in India. This may be since they do not want to dilute their control over the business. Further, since India’s bond market is underdeveloped, information asymmetry and transaction costs of market-oriented financing strategies remain high. In contrast to public debt, the problem of information asymmetry and transaction cost in private debt is low as the private lenders have superior firm-specific information. The combined effect of family ownership and dominance of banks and financial institutions has led to private debt (lending from banks and financial institutions) being a preferred financing mode as compared to public debt (issuance of debt instruments in the bond market).
The regulatory developments in relation to family-owned companies have been rather mixed. Founders or founder families do not want to lose control of their companies and cannot afford their companies being declared insolvent. By overhauling the entire insolvency law framework and making it more robust, the Ministry of Corporate Affairs, Government of India (‘MCA’) has sought to revive the disciplining effect of bankruptcy. Most importantly, the Insolvency and Bankruptcy Code, 2016 (the Code) vide a subsequent amendment, has introduced Section 29A which aims to debar persons who contributed to the defaults of the corporate debtor by their misconduct or are otherwise undesirable, from gaining or regaining control of the corporate debtor during the resolution process. This provision prevents unscrupulous persons from rewarding themselves at the expense of creditors. For instance, a promoter who is a wilful defaulter or was involved in any fraudulent transaction cannot regain control of his own company or any other company which is undergoing insolvency resolution process. Thus, phoenixing is barred so as to prevent such persons from gaining control of such companies at a discounted rate leading to losses for the creditors. However, this provision in practice has been diluted as the liquidation regulations have allowed persons barred under Section 29A to enter into a scheme of compromise (under Section 230 of the Companies Act, 2013) with the creditors. This move is counter-intuitive to the object of Section 29A of the Code even though aimed at higher recovery for creditors.
Promoters largely manage finances of their companies by taking loans against shares. Based on data provided by BSE – the oldest Indian stock exchange with the highest number of companies listed – 830 companies have pledged shares worth more than INR 1,87,000 crores. As banks cannot lend more than INR 20 lakhs to a single entity against shares, promoters borrow from non-banking finance companies (also known as shadow banking institutions). An industry survey suggests that due to the recent defaults by certain promoter groups, the effective interest rates for loans against shares has risen in the range of 200 to 400 basis points compared to last year. This is despite the fact that there has been a continued reduction of interest rates by the Reserve Bank of India. Further, Securities and Exchange Board of India (SEBI) has recently cracked down on pledging of shares and has demanded enhanced disclosures regarding reasons for pledge of shares if such pledged shares exceed 20% of the share capital of the company or 50% of the promoter holding.
From the perspective of regulating companies which have family ownership, a study of the prolonged history of corporate frauds in India reveals two areas of critical importance – auditor independence, and board independence. While independent directors are tasked with general oversight of the company and to prevent abuse by controlling shareholders, auditors on the other hand are tasked with the responsibility of monitoring finances and detect instances of fraud or financial irregularities.
Independent directors have met with huge criticism, barring some honorable exceptions, particularly due to the low level of independence displayed by them. The term ‘independence’ in corporate board dynamics means that independent directors must be independent from the company and its executive and controlling shareholders and that they must be independent to act in the best interests of their fiduciaries. It is difficult to assume independence (in relation to controlling shareholders) when independent directors are appointed by controlling shareholders. Thus, in order to ensure that minority shareholders’ interests are protected, appointment of independent directors must be approved by all shareholders and the non-controlling shareholders separately as provided in the UK Listing Rules for premium listed companies. In case of disapproval by the minority shareholders, a resolution for appointment may again be presented after a cooling off period of 90 days. However, the threat of reputational loss upon the defeat of a proposed appointee disciplines the controlling shareholders to appoint credible persons who may be well-accepted for their independence by the non-controlling shareholders. Since independent directors form a majority of the Audit Committee of the Board of Directors, such appointment mechanism shall also strengthen the functioning of the Audit Committee which plays a critical role in monitoring the finances of the companies. Furthermore, it is also opined that in India, the role of an independent director must vary depending on the ownership structure of the company and the nature of the controlling shareholder, whether it is a family business group or the state.
The role of auditors in a company is also under the scanner – not only in India, but also globally. Apart from the structural vulnerabilities of audit firms for which they are largely occupying headlines, the crucial aspect that remains is the role of statutory auditors in case of family controlled companies. Similar to independent directors, auditors are also regarded as gatekeepers of corporate governance. Thus, auditor independence is essential for audit quality. Past instances of fraud have displayed the inter-connectedness between promoters and auditors. Hence, similar to the case with independent directors, the role of non-controlling shareholders in the appointment of auditors must also be enhanced.
Banks and financial institutions have to also be aware of the atypical problems with family-owned companies. They need to look beyond profitability and existing relationships to ensure periodical due diligence regarding the end-use of funds lent by them to such companies. The CVC Report, which studied top 100 bank frauds in India, also highlighted certain glaring lapses in due diligence – in one instance, a company produced a use-of-funds certificate that was signed by an auditor other than the one who audited the company’s financials. It has further highlighted how banks do not make independent assessment of the borrower in case of consortium lending. It is important for banks and financial institutions to adopt a case-specific approach – particularly for dealing with tunneling in case of family-owned companies.
Neither does this article aim to put all family-owned companies in bad light, nor does it advocate for a dispersed ownership structure. It merely endeavours to draw the attention of the policy makers in the direction of having a different regulatory approach. Regulatory policies must account for the unique circumstances in so far as financing such companies is concerned. While there is prominence of dispersedly-held companies in the UK, the UK Listing Rules has a dedicated chapter on controlling shareholders and also certain additional legal requirements (such as approval of non-controlling shareholders for appointment of Independent Directors) which such shareholders (and the companies) need to adhere to. SEBI should consider enhanced disclosure and other requirements (such as dual voting requirement for appointment of independent directors) for companies with substantial holding of promoter and promoter group. The additional disclosure requirement for pledge of shares is a step in the right direction.
The recently constituted National Financial Reporting Authority, which now serves as the apex body for regulating the auditing profession, must account for serious infractions of auditor-promoter relationship and accordingly recommend changes to be made to auditor’s appointment process along with ensuring their effective oversight, to the MCA and SEBI, particularly in case of family-owned companies.
Banks and financial institution are key players in the entire financial ecosystem. They must identify areas in case of family-controlled companies which require constant monitoring. Further, if financial institutions hold equity in family-owned companies (generally by way of debt-to-equity conversion), they must take a proactive role to improve corporate governance practices at such companies. This may require banks and financial institution to built capacity in this regard. Leveraging technology for developing a robust internal control mechanism must also be prioritized. The Reserve Bank of India must also ensure that systemic checks and balances are put in place to require banks and other financial institutions to take effective steps in this direction. The Y.H. Malegam Committee was constituted in the aftermath of the PNB Scam and is yet to submit its report. Given that, in order to keep a check on the rising number of promoter-driven frauds, the Committee must consider recommending specific measures while lending to family-owned companies for greater transparency in financial transactions involving family-owned companies.
* Mr. Param Pandya is an alumnus of Gujarat National Law University, Gandhinagar. After working with Cyril Amarchand Mangaldas, Mumbai and Vidhi Centre for Legal Policy, New Delhi, he is pursuing M.Sc. Law and Finance at the University of Oxford as the J N Tata Scholar (2019-2020). The author is thankful to Debanshu Mukherjee, Team Lead, Vidhi Centre for Legal Policy, New Delhi and Shehnaz Ahmed, Senior Resident Fellow, Vidhi Centre for Legal Policy, New Delhi for a fruitful discussion which led to this article. The author is also thankful to Khushi Maheshwari for her research assistance. Views are personal and errors, if any, are author’s alone.
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 The author refrains from delving into which definition of ‘family-owned companies’ is exhaustive or best represents this classification. Thus, various sources referred in this article may refer to a different definition of family-owned companies.
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 For agency cost analysis between owners and creditors see, A. Damodaran, Corporate finance, New York: John Wiley, (1997). Founder/ family generally embark on risky projects which may be aimed at enhancing reputation or owed to family values. This may also increase cost of finance and reduce the value of outstanding debts. While success of such projects may incentivise majority shareholders with high returns (both monetary and at times non-monetary), creditors get fixed rate of return. Further, creditors will have to bear the brunt if such project/s fails. See generally, Brahmadev Panda and N.M. Leepsa, Agency theory: Review of Theory and Evidence on Problems and Perspectives, Indian Journal of Corporate Governance (2017).
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 Santanu K. Ganguli, Capital Structure- does ownership structure matter? Theory and Indian Evidence, 30(1)Studies in Economics and Finance,(2013).
 Despite regime changes, there has been a persistence of concentrated family ownership of Indian companies throughout the last century. See, Tarun Khanna and Krishna Palepu, The Evolution of Concentrated Ownership in India: Broad Patterns and a History of the Indian Software Industry, A History of Corporate Governance Around the World: Family Business Groups to Professional Managers, 285 (Randall K. Morck, editor, 2005); CFA Institute, Corporate Governance for Asian Publicly Listed Family-Controlled Firms,2017, available at https://www.arx.cfa/up/post/4229/Corp%20Gov%20for%20Family%20Controlled%20Firms%20APAC.pdf (Last visited 20 August 2019).
 Note that the term promoter and promoter group is largely an Indian conceptualization of control of founders and/ or founder family. This Article uses these terms interchangeably.
 The study defined ‘family-owned’ company as a company where the: (a) direct shareholding by founders or descendants is of at least 20%. (b) voting rights held by the founders or descendants is of at least 20%.
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 These 6 sectors include Agro, Media, Aviation, Services/ Projects, Trading and Information Technology.
 Abhinav Chandrachud, The Emerging Market for Corporate Control in India: Assessing (and Devising) Shark Repellents for India’s Regulatory Environment, 10 Washington University Global Studies Law Review 189 (2011).Indian economy has been dominated by banks, particularly, nationalised banks. Thus, having relationships with politicians played a key role in getting finances from banks which were under state control. See, Tarun Khanna and Krishna Palepu, The Evolution of Concentrated Ownership in India: Broad Patterns and a History of the Indian Software Industry, A History of Corporate Governance Around the World: Family Business Groups to Professional Managers, 283, 294 (Randall K. Morck, editor, 2005).
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 Santanu K. Ganguli, Capital Structure- does ownership structure matter? Theory and Indian Evidence, 30(1) Studies in Economics and Finance, 2013. See also, Kaushik Basu and Meenakshi Rajeev, Determinants of Capital Structure of Indian Corporate Sector, The Institute for Social and Economic Change Bangalore, Working Paper 306, 2013.
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 Statement of Objects and Reasons of the Insolvency and Bankruptcy Code (Amendment) Bill, 2018. This Bill (later Act) introduced Section 29A to the Insolvency and Bankruptcy Code, 2016.
 While India does not have the concept of a supervisory board, Independent Directors are non-executive directors who are appointed under Section 149, Companies Act, 2013. These directors generally perform a monitoring function. For history and evolution of Independent Directors ,see, Vikramaditya S. Khanna and Umakanth Varottil, Board Independence in India: From Form to Function?, In Dan W. Puchniak, Harald Baum and Luke Nottage (eds.), Independent Directors in Asia: A Historical, Contextual and Comparative Approach (23 March, 2016). See generally, J.N. Gordon, The Rise of Independent Directors in the United States, 1950- 2005: Of Shareholder Value and Stock Market Prices, 59,Standford Law Review, 1465 (2007).
 Lucian A. Bebchuk and Assaf Hamdani, Independent Directors and Controlling Shareholders, 165(6), University of Pennsylvania Law Review, (2017).
 UK Listing Rules, Rule 9.2.2E R.
 Vikramaditya S. Khanna and Umakanth Varottil, Board Independence in India: From Form to Function?, In Dan W. Puchniak, Harald Baum and Luke Nottage (eds.), Independent Directors in Asia: A Historical, Contextual and Comparative Approach (23 March, 2016).
 UK Listing Rules, Chapter 6.5.