The Hindu Business Line : Dysfunctional financial activism

The arguments of information and investment activists are aimed at altering the flow of information or cash flows or both from closely-held companies. These arguments assume that the right to privacy is negotiable and somehow ignore the more important contribution that closely-held companies make through expanding employment and enlarging the basket of goods and services, says G. Ramachandran.

IT IS ironical that some analysts should present a strong, convincing case for greater economic freedom of the private sector and simultaneously suggest that private, closely-held companies should be divested of two of their principal rights. First, a case has been made that a private company has no special right to keep its financial numbers to itself because the company exists in India, transacts with customers in India and employs Indian citizens.

These `information activists' argue that private, unlisted companies should supply their comprehensive income statements and balance-sheets to the public in the same manner as a company whose shares are owned by public shareholders and are listed on a domestic stock exchange.

Second, a case has been made that private companies, especially multinational corporations (MNCs), should offer their shares to public shareholders. The `investment activists' have argued that private, unlisted companies should offer their equity to public shareholders and that the listing of shares should be a prerequisite that they should fulfil before being permitted to operate in India. Both forms of financial activism violate the right to privacy.

The right to privacy is among the principal economic freedoms. It should be espoused with great vigour so that businesses in India can build their competitive strengths without the fear that these strengths would be snatched away by their rivals through dubious and dysfunctional rules. Private, unlisted companies contribute significantly to India's competitiveness. This source of competitiveness should not be undermined.

Driven by mutuality

A company owned by public shareholders has a contract with shareholders to supply information pertinent to the company's performance. This contract is an integral part of the framework that governs the supply of tradable equity and debt to widely-held companies.

Widely-held companies comply with disclosure requirements because the supply of public equity and debt offers them four important benefits. First, external capital enhances their size and, therefore, their ability to pursue large, complex projects. Second, external capital from numerous shareholders lowers the overall risk borne by any shareholder. Third, access to public savings allows widely-held companies to outlast closely-held companies through many business cycles and through many ups and downs. Fourth, the overall cost of capital of a widely-held company declines relative to that of a closely-held company as a result of the three preceding advantages. To reap these important benefits permanently, widely-held companies agree to provide financial and non-financial disclosures periodically. Without adequate and periodic disclosures, the supply of tradable capital by numerous shareholders will decline or fail altogether. When the likelihood of supply of public capital declines, the four competitive advantages begin to lose vigour. Information activists have ignored the quid pro quo and the trade-off.

Purposes and means

The public's right to information follows from the fact that a public shareholder or bondholder can sell equity shares or bonds to someone else independent of the involvement of a widely-held company. This right does not stem from any other relationship that the widely-held company may have with the public. The right to information is not predicated on whether the widely-held company exists in a particular society, transacts with customers in that society and employs that society's citizens. Financial markets, accounting standards and disclosure rules can do little to improve the relationship between a business and its customers and employees. It would be both naïve and futile to expect financial markets, accounting standards and disclosure rules to improve the relationship between a business and its customers and employees when legislation and courts, product markets, consumer protection forums and labour markets fail to do their duty.

A wholly private affair

The shareholders of a closely-held company have access to information pertinent to the performance of that company. This is a basic right. But the access is restricted to the shareholders of that company. It is difficult to accept the information activist's argument that it is a special right that could be done away with. Why should anyone else know about the financial numbers and the non-financial characteristics of a closely-held company? Would not the company and its shareholders lose some information of competitive value by giving away information to outsiders? At the same time, there is nothing that a closely-held company would gain by providing the same set of disclosures that a widely-held company provides. In the main and by design, a closely-held company does not seek capital from the public. It uses private savings and does not seek public savings to enhance its size and the capital that it deploys. It does not seek public savings to lower its weighted-average cost of capital and the riskiness of its returns. A closely-held company does not seek any quid pro quo and trade-offs vis-à-vis the public. It is wholly private, and derives all its advantages and disadvantages from its private shareholders. A closely-held company voluntarily rejects the sources of the four competitive advantages in favour of other undisclosed competitive advantages. It is apt that these competitive advantages remain the private property of private shareholders.

Much to lose

However, if disclosure requirements that govern widely-held companies were thrust on closely-held companies, the latter will lose control over such information that is somehow related to their competitiveness and sources of competitiveness. It is common knowledge among bankers, financial analysts, venture capitalists and strategic analysts that income statements and balance sheets can be methodically analysed to gain insights into a company's competitiveness. If rivals of closely-held company could have access to such information and insights, closely-held companies will have something vital to lose forever. Unbridled access to information may appear fashionable, but where such information is about rivals, all businesses in an industry would be vulnerable to the loss of competitiveness.

The decision by a closely-held company in such circumstances to stop being in business in India would be rational. The decision by a closely-held company in India to put off futures investments would also be rational. The loss of competitiveness is the principal issue, and India would be staking its economic future in the name of access to information.

The prospects of loss of control over information related to competitiveness cannot be ignored by both Indian-owned closely-held companies and foreign-owned closely-held companies. It would, of course, look silly if India were to enact laws that will somehow exempt Indian-owned closely-held companies from some disclosure rules.

Yearning for MNC stock

The notion that domestic investment needs would be attractive to global investors has influenced policy towards foreign direct investment (FDI) and portfolio investments. The notion that FDI could make a vital difference to the quality of the domestic asset markets and practices has influenced some of the components of policy. Mandatory offering of equity to domestic investors could be regarded as an example.

There are many that think that the quality of the domestic primary and secondary markets could be improved rapidly if all foreign companies issued stock to public investors. Investment bankers were fond of propagating this view. Issuance of stock has been regarded as a favour done to investors. They have asked if it would be too much to suggest that MNCs should be forced to offer their stock in India. These point to a yearning for MNC equity shares.

An avoidable pattern

The arguments of information and investment activists have many common characteristics. In the main, they are aimed at altering the flow of information or cash flows or both from closely-held companies. These arguments assume that the right to privacy is negotiable and somehow ignore the more important contribution that closely-held companies make through expanding employment and enlarging the basket of goods and services. A large part of economic activity takes place in the private sector outside of the scope of the public financial markets.

Moreover, the private closely-held sector accounts for more than 94 per cent of all new investments, jobs, incomes and exports. It is a pity that the expansion of employment and the enlargement of the basket of goods and services have become subordinate to the objectives propagated by information and investment activists. If the costs of complying with the objectives propagated by information and investment activists exceed the benefits from employing Indian talent in India to serve Indian and global customers, Indian-owned closely-held companies and MNC-owned closely-held companies would choose to get out of India.

Or, they would choose not to get into business in India. The choice is ours. By ripping the right of businesses to their economic privacy, we would have ripped our economy publicly.

(The author is a financial analyst. Feedback may be sent to indiagrow@sify.com)

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