Of late, a new breed of equity research and advisory firms have been acting as whistle-blowers when companies follow dubious accounting or governance practices. But investors should know that there are risks to this trend.
Despite elaborate laws, multiple regulators and frequent disclosures, some Indian companies refuse to tread the straight and narrow path of corporate governance. Auditors, shareholders and institutional investors who should discourage them, seem barely interested.
This has given rise to a new breed of forensic accountants, research firms and proxy advisory firms, who have been alerting markets to instances of corporate shenanigans.
But this trend of private entities acting as whistle-blowers on governance issues carries risks.
The recent fracas between Canadian equity research firm, Veritas, and the IndiaBulls group is a case in point.
Nothing but the truth?
The facts of this case are simple.
In a report dated August 1, Veritas released a provocative research report titled ‘Bilking India’, asking investors to sell their shares in three companies belonging to the IndiaBulls group.
In rather colourful language, the report alleged that the financials of two firms were ‘unreliable’ and one firm was being run as a ‘piggybank’ for the controlling shareholders, at the cost of public investors.
Veritas illustrated its point with examples. It objected to IndiaBulls Power merging a group entity into itself at high valuations, the listed companies giving loans and advances to related parties and routing lucrative business to private entities controlled by promoters. This ‘intricate web’ of related party dealings made the entire group’s financials hard to decipher, lamented the report.
The report found its way into the public domain on August 8 and the stocks of the three firms were battered by over 10 per cent each within the trading session, before recouping.
While all this isn’t unusual, what happened thereafter is. Unlike most other firms that are the target of ‘sell’ ratings or downgrades by analysts, IndiaBulls was quick to strike back with counter-allegations.
Dashing off a letter to the stock exchanges, IndiaBulls accused the report of factual inaccuracy and the Veritas analyst of mala fide intentions. It has also filed a police complaint against the analyst for demanding money for holding back the report, ahead of its release.
The whole episode raises some interesting questions.
One, if IndiaBulls indeed found factual inaccuracies in the report, why doesn’t it issue a point-by-point rebuttal for it, with numbers? After all, that may have helped restore investor confidence quicker than counter-allegations.
Two, given that Veritas claims to be an independent equity research firm without any broking affiliate, what is its revenue model? Surely, research outfits do not issue reports just to do public good.
If they earn revenues by selling bespoke research to institutional clients, are the reports released to these investors ahead of others? If so, do public investors lose by being late on the bandwagon? To be fair, these are questions to be asked not just of Veritas, but of the many equity research firms that have been flagging accounting or governance issues of late.
In July, there was a war of words between research firm Credit Suisse and JSW Steel on allegations that the latter was understating its debt position. Macquarie had similarly flagged ‘aggressive accounting’ by the country’s largest mortgage lender, HDFC, only to have the latter challenge its report.
But the most surprising part of the whole episode was the stock price reaction. Now, Veritas admits that its findings about the IndiaBulls companies are sourced entirely from their public filings and financial statements.
Why, then, did the stock react so strongly to the revelations? Does this mean that hardly any investors, including institutional ones, read a company’s annual report or public filings?
Not a substitute
The above facts, in fact, reveal why equity research firms or advisory firms, however independent or well-meaning, cannot stand in for statutory auditors or shareholders, when it comes to enforcing good governance.
Seasoned investors will also tell you that practices such as merging group entities at inexplicable swap ratios, largesse to related parties and using promoter firms to sub-contract work are not exactly unheard of. In fact, reputed business groups and multinational companies have used these ploys. Yet, they usually get away with them because, despite having many statutes on corporate governance — the Companies Act, the listing agreement with the exchanges and SEBI’s disclosure and investor protection guidelines — enforcement of these laws is lax. Take the case of a company not adhering to accounting standards or using doubtful accounting that overstates its profits or assets. Alerts to such practices are supposed to come first and foremost from a company’s auditor, in the form of an adverse or qualified opinion on its financial statements.
But in practice, auditors go to great lengths even to avoid a qualified opinion, instead taking refuge under various notes, ‘subject to’ and ‘emphasis of matter’ clauses.
Kingfisher Airlines’ 2010-11 annual report attracted nearly half a dozen references to notes and qualifications by its auditors, including one questioning its ‘going concern’ assumption. Yet, the financial statements were certified as ‘true and fair’!
This is where one wishes that auditors’ statements were as forthright as Veritas’ reports.
Then there is the fact that companies simply cannot over-stretch borrowing limits, lend to related parties or put through mergers and buyouts without the sanction of the majority of their shareholders.
Yet, these proposals routinely go through without contest because individual shareholders don’t even seem to participate in meetings or postal ballots.
The irony is that enforcing high standards of corporate governance should not be difficult in the Indian markets, because over two-thirds of the publicly available shares are actually held by institutions — whether foreign investors, mutual funds or insurance companies.
These investors are surely savvy enough to dissect corporate actions and protest against malpractice, even if they don’t manage to actually scuttle proposals that are patently inimical to investor interests.
But mutual fund houses seem to be content to vote with the management while foreign institutional investors seem intent only on making quick gains.
It is up to retail investors therefore, to exercise their best judgment when private whistle-blowers get into the act.
Note: Since the publication of this article, the IndiaBulls group has issued factual clarifications on the points raised by Veritas.