SHARE PLEDGING AND ITS CONSEQUENCES: A STUDY OF INDIAN FIRMS

“Policy makers and investors need to take a more balanced and contextual view on share pledging by family promoters rather than castigating the phenomenon.”

A research study, authored by Dr. Nupur Pavan Bang, Professor Sougata Ray, Nandil Bhatia and Professor Kavil Ramachandran of the Thomas Schmidheiny Centre for Family Enterprise at the Indian School of Business (ISB), highlights the prevalence of share pledging in the Indian context and the possible implications that pledging may present for stakeholders, especially in family firms.

Using data for 1,492 firms listed on the National Stock Exchange of India from 2009 to 2019, the study finds a decline in firm value, higher crash risk and underinvestment in innovation by firms where promoters of family firms pledge their shares. The study also shows how some firms have utilized share pledging by family promoters as a tool to raise capital for strategic projects and create value for the stakeholders.

The various scandals, loss of control of the firm by family promoters, regulatory responses and warnings led to the common perception that all share pledges by promoters are bad. Existing empirical research around pledging of shares is sparse and does not account for the heterogeneity among the possible use-cases of capital obtained from pledging of shares. The study calls for more nuanced studies on pledging to explore this anomaly contextually and to avoid painting all cases with the same brush.

Co-author, Professor Sougata Ray explains that “the commonly peddled negative narrative on pledging often dissuades fact based, informed, balanced, and nuanced debates on its utility, causes and consequences, backed by rigorous research in spite of its ubiquity in India and many other economies of the world. Along with large sample data driven research, there is a need for case study based research on pledging in order to understand the variations of the same.”

The study was released in a webinar in the presence of Dr. Satyanayana Chava, Founder and CEO, Laurus Labs; Professor Prasanna Tantri, Executive Director, Centre for Analytical Finance, ISB; the authors of the study; and industry stakeholders. It has important implications for investors, regulators, board of directors, and even family members. Pledging of shares, coupled with bad decision-making and/or over ambitious growth plans, resulted in complete destruction of family wealth in many family firms. There is need to create awareness and build stronger family governance processes that would put checks and balances with regards to excessive pledging.

Speaking at the webinar, Dr. Nupur Pavan Bang said, “The study provides a clarion call for acknowledging that pledging is an important tool to access financial capital for family promoters. It is a legitimate way to raise entrepreneurial financing amongst family businesses and a source of fund to turnaround the family firm if it is in trouble. Policy makers and investors need to take a more balanced and contextual view on share pledging by family promoters rather than castigating the phenomenon.”

The study lists important implications for stakeholders of family firms, such as, promoters, family members of the promoting family, investors, the firm’s board of directors, and the regulators. A few of them include:

-        Over-optimistic investment plans and over-pledging of shares by the promoters, without pre-planned repayment strategies, are likely to lead to a crisis later.

-        Investors must keep a track of their portfolio and regularly evaluate if the controlling shareholders of the firms in which they have invested have pledged their shares.

-        Board of directors of firms must caution controlling shareholders from over pledging their stakes and should shield the firm from such shareholders if they try to manage the margin calls by taking hasty or short-term view decisions in the firm.

-        The study also has insights for the regulators such as the RBI and SEBI to take more balanced view of pledging when making policies.

-        Further, there is need to create awareness and build stronger family governance processes that would put checks and balances with regards to excessive pledging.

India’s Family-Ownership Factor

This article was first published by the Global Association of Risk Professionals, Risk Intelligence, November 26, 2018

https://www.garp.org/#!/risk-intelligence/market/investment-management/a1Z1W000004BThsUAG

Study underscores preeminent role of family-controlled businesses, even as multinational and holding-company investments rise

Promoters (founding shareholders/owners) of family firms have increased their shareholdings while non-promoters, institutional as well as small non-institutional investors, have reduced their stakes, a study by the Thomas Schmidheiny Centre for Family Enterprise at the Indian School of Business (ISB) reveals.

Authored by Dr. Nupur Pavan Bang, Professor Kavil Ramachandran and Anierudh Vishwanathan of the Thomas Schmidheiny Centre, and Professor Sougata Ray of Indian Institute of Management-Calcutta, Family Businesses: Promoters' Skin in the Game finds that a pattern of declining stakes by promoters in BSE 500 companies, as shown by some prior analysis, is not true for all categories of firms. Confining the analysis to BSE500 firms does not give a true picture, as the BSE500 excludes most of the smaller, standalone family firms.

The study provides insights into the ownership pattern of family, as compared to non-family, firms and explores the heterogeneity within family firms. The study covers trends in equity ownership by various classes of shareholders for 4,615 firms listed on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE), across different ownership categories, for the 2001-2017 period.

Key Findings

Rising promoters' stake. In India, family-controlled firms are greater in number than non-family firms. Lack of a strong legal framework to protect minority shareholding and other institutional voids make concentrated ownerships natural in India.

By steadily increasing their shareholdings, the promoters of family firms – both family business group firms (FBGFs) and standalone family firms (SFFs) – signal their growing confidence in the potential of their company, thereby instilling confidence among the investors.

Promoters of multinational corporations (MNCs) have also increased their stakes in Indian subsidiaries, probably indicating their belief in the “India story.” The promoter stake in State Owned Enterprises (SOEs) has been steadily falling over the past decade. 

This is in line with the policies of successive India governments to divest their holding in SOEs. Other business group firms (OBGFs) and standalone non-family firms (NFs) have also witnessed a decrease in promoter shareholding.

Rising trend of holding shares through companies. In FBGFs, the preferred mode to hold shares is through holding companies, while in SFFs the family members prefer to hold shares directly as individuals or as Hindu Undivided Family (HUF). 

In FBGFs, holding companies or trusts that hold shares of all companies on behalf of the family members enable better resource allocation, control, realization of synergies and tax planning within all group-level firms, and better management of ownership, inheritance and payouts at the family level. It also enables the family to professionalize each firm, while the family maintains a bird's eye view at the group level.

SFFs are younger, with less complex structures, both at the family and the business front. As they grow, complexities of inheritance, succession and growth would force them, too, to adopt better ownership structures. Therefore, we see a gradual increase in shareholding through companies even in the case of SFFs.

Declining institutional shareholding in family firms. Non-promoter institutional shareholding is lower in family firms when compared with non-family firms, and it has decreased further between 2007 and 2017.

As block holders, institutional shareholders influence the governance and strategy of the firm; if they refrain from investing in family firms, the pursuit of governance will take longer. Non-family firms in general have strong formal internal control mechanisms to keep the personal interests of managers out of the company's functioning.

Consequently, the probability of a strong and independent corporate governance mechanism is greater for a non-family firm. Institutional investors have a strong preference for firms with good governance. Thus, we see higher institutional shareholding in NFs and OBGFs.

Reluctant non-institutional shareholders. Except in NFs, the study shows a decline in the shareholding of non-promoter, non-institutional shareholders. It suggests that investors' preferences might have further shifted to alternative asset classes like real estate, gold, and fixed deposits, or they might be investing through institutions like mutual funds.

Most of the decline is due to small investors with up to Rs1 Lakh worth of shares. These small investors have reduced their holdings across all ownership categories. This may be due to the lack of disposable income in the hands of small investors.

Conclusions

This study has attempted to give a bird's eye view of the shareholding pattern of listed Indian firms. We found that promoters of family firms have increased their stake in their companies over the last decade, while SOEs, OBGFs and NFs have seen a decline in promoter shareholding.

This reinforces the preeminent role of family-controlled businesses in India. It seems to imply that the engine of growth of Indian businesses will not be dependent on overseas or other promoter categories. Instead, promoters of family firms will continue to play a major role.

The ownership pattern of listed businesses in India is fairly concentrated, especially in the case of family firms, SOEs and MNCs. While this has significant positive effects, there is also a need to keep close vigil on their governance practices.

Family firms up stake over last decade in India: Research

Promoters of family firms have increased their stake in their NSE and BSE listed companies over the last decade, findings of a research study released here today revealed. 

Indian School of Business (ISB)'s Thomas Schmidheiny Centre for Family Enterprise conducted the research study "Family Businesses: Promoters' Skin in the Game 2001-2017," which reveals the pattern of increasing stake of promoters in NSE and BSE listed family firms. 

The study, conducted by Dr Nupur Pavan Bang, Professors Kavil Ramachandran and Anierudh Vishwanathan of the Centre and Professor Sougata Ray of IIM Calcutta, provides insights into the ownership pattern of family firms in comparison to the non-family firms and also explores the heterogeneity within family firms. 

It is a first-of-its kind research study that presents and analyses the trends in equity ownership by various classes of shareholders for 4,615 firms listed on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) of India, across different ownership categories, for the period 2001- 2017, according to ISB. 

The research study attempted to give a bird's eye view of the shareholding pattern of listed Indian firms. 

Dr Nupur Bang said, "We found that promoters of family firms have increased their stake in their companies over the last decade, while State owned Enterprises (SOEs), Other Business Group Firms (OBGFs) and Standalone Non-family Firms (NFs) have witnessed a decline in promoter shareholding." 

This, she said, reinforces the preeminent role of family-controlled businesses in India. 

It seems to imply that the engine of growth of Indian businesses would not be dependent on overseas or other promoter categories. 

Instead, promoters of family firms would continue to play a major role. 

Executive Director of the Centre, Professor Kavil Ramachandran said the ownership pattern of listed businesses in India is fairly concentrated, especially in the case of family firms, SOEs and MNCs. 

While this has significant positive effects, there is also a need to keep close vigil on their governance practices, he added. 

The research study found that while the concentration of promoters' shareholding is decreasing in non-family firms, it is increasing in the family firms. 

By steadily increasing their shareholding in the firm, the promoters of family firms, both family business group firms (FBGFs) and standalone family firms (SFFs), were signaling their growing confidence in the potential of their company, thereby instilling confidence among the investors. 

Promoters of MNCs have also increased their stake in their Indian subsidiary, probably indicating their belief in the 'India story.' 

The promoter stake in SOEs has been steadily falling over the past decade. 

This is in line with the policies of the successive governments in India to divest their holding in the SOEs. 

OBGFs and standalone non-family firms (NFs) have also witnessed a decrease in promoter shareholding. 

Non-promoter institutional shareholding is lower in family firms when compared with non-family firms and it has decreased further between 2007 and 2017, the study noted. 

The press release was covered in several newspapers, magazines and websites, including: Business Standard, The Hindu Businessline, BL on Campus, Times of India, Business Standard, The Economic Times, ETCFO, Financial Chronicle, Financial Express, Asian Age, Deccan Chronicle, India Today, Business Today, The Week, Telangana Today, Eenadu, Sakshi, Andhra Jyothi, Hans India, PTI, Millenium Post, IndiaFinancenews, Newsfeed.co.in, Devdiscourse, Dailyhunt, Bullfax.com, Hunterinfo.in, Technologyforyou,com

Entire study can be accessed and read at: https://www.isb.edu/sites/default/files/Family_Business_Promoters_skin_in_the_game_1.pdf

The Complement of Credibility

This Research Summary was first published in the IIB Bulletin, 2015, Vol. 1, Iss. 3, pp8-9 

https://iib.gov.in/IRDA/Articles/IIB%20Bulletin%20Q3%202014-15.pdf

Co-Author: Vishnuvardhan Pallreddy, IIB

Joseph A. Boor, FCAS, Ph.D. has been a working casualty actuary since 1979 and a Fellow of the Casualty Actuarial Society since 1988. Over a long and varied career he has had roles as diverse as regulator, Chief Actuary, consultant, and regional actuary. Currently, he works as an actuary for the Office of Insurance Regulation of the State of Florida in Tallahassee, Florida. He is the author of several published articles, including theoretical contributions to the theory of credibility and the optimum weightings of years of data and single-topic ratemaking papers on the complement of credibility in pricing and tail factors in loss reserving. He has a Bachelor’s of Arts degree in Mathematics from Southern Illinois University in Carbondale, a Master of Science degree in Mathematics from Florida State University, and a Doctor of Mathematics degree from Florida State University.

Complements have a special role in ratemaking exercises where the data is sparse or has high deviation from the mean over the years and hence has low credibility. “The Complement of Credibility” paper by Joseph A. Boor (1996) provides a good overview of the qualities and effectiveness of a good credibility complement and explains different credibility components commonly used. The paper also looks at the practical aspects of selecting a complement.

Overview

According to the paper, “The complement of the credibility deserves at least as much actuarial attention as the base statistic (historical loss data)”. Special attention should be given to its unbiasedness and accuracy. In some cases, interdependence must be avoided. Ease of computation and implementation must be reasonable. Explainability of statistics used must be considered, too.

Fundamental Principles

The paper explains a few issues that an Actuary must consider before selecting the complement of credibility:

Practical Issues: Complement should be readily available. The best possible statistic to use is the next year’s loss costs which are unknown. It has to be chosen from the available statistics. Ease of computation would also be a factor to consider as it involves time, costs and also increased chances of error.

Competitive Market Issues: The rates that are eventually produced will be subject to market competition. If rates are too high or too low, the outcome will not be desirable. So, the rate should be neither too high nor too low over a large number of loss cost estimates (unbiasedness) and the rate should have as low an error variance as possible (accuracy).

Regulatory Issues: Regulators typically require that the rates are not inadequate, not excessive, and not unfairly discriminatory. This implies that rates should be as unbiased as possible. It could also be implied that rates should be as accurate as possible, as highly inaccurate rates pose a greater risk of insolvency through random inadequacies.

Statistical Issues: For greater accuracy, error variance should be lower. If complement of credibility has low error variance in its own right and relatively independent of base statistic (which receives the credibility), the resulting rate will be more accurate.

When both the base statistic and complement are unbiased, the predictions are generally best when there is actually a negative correlation between the two errors (that is, they offset) but this rarely occurs in practice. So, a complement of credibility is best when it is statistically independent of the base statistic.

Based on the above four issue that must be considered by an Actuary when selecting a complement, Boor summarizes the desirable qualities that a complement of credibility should have:

1.       Accuracy as predictor of next year’s mean loss costs

2.       Unbiasedness as a predictor of next year’s mean subject expected losses

3.       Independence from the base statistic

4.       Availability of data

5.       Ease of computation

6.       Explainable relationship to the subject loss costs

Commonly used Components

Boor goes on to compare different types of complements used by Actuaries for First Dollar Ratemaking and Excess Ratemaking. Few often used methods for First Dollar ratemaking discussed in the paper are:

·         Using loss costs of a larger group including the class-Bayesian Credibility

·         Using loss costs of a larger related class

·         Harwayne’s method

·         Trending present rates

·         Applying the rate change from a larger group to present rates; and

·         Using competitors’ rates

For Excess Ratemaking, the four methods discussed in the paper are:

·         Increased limits factors

·         Derivation from a lower limits analysis

·         Analysis reflecting the policy limits sold by the insurer; and

·         Fitted curves

The use of the complement of credibility may differ from case to case, depending on the “availability of data” and reasonability of effort. For example, in the case of excess (or large) losses, fitted curves uses data available with the Insurers and is generally unbiased, but is complex to compute and may be difficult to communicate as well.

For pure premium ratemaking, using competitors’’ rates may be easy to use, especially for new companies or companies with low experience, but may suffer from inter-company difference in portfolio mix and may be harder to obtain.

“In Harwayne’s method, actuaries use countrywide (excepting the base state being reviewed) class data to supplement the loss cost data for each class, but they adjust countrywide data to remove overall lost cost differences between states (or provinces)”.

Many such practical insights on the above listed methods are provided in the paper along with the model itself and examples. As the Indian market moves towards an era of ratemaking, his paper is a valuable guide to the choice of a complement of credibility. The paper can be read at the following link: https://www.casact.org/pubs/proceed/proceed96/96001.pdf

Reference:

Boor, Joseph. A., “The Complement of Credibility" (Proceedings of the Casualty Actuarial Society,  Vol. LXXXIII, Part 1, No. 158, 1996, 32p; https://www.casact.org/pubs/proceed/proceed96/96001.pdf

Research Summary: Moral, Social, and Economic Dimensions of Insurance Claims Fraud

This research summary was first published in the IIB Bulletin, 2014, Vol. 1, Iss. 1, pp-8-9; Co-author: Vishnu Vardhan Pallreddy

https://iib.gov.in/IRDA/Articles/IIB%20Bulletin%20Q1%202014-15.pdf

Professor Sharon Tennyson of the Department of Policy Analysis and Management at the Cornell University, is an active researcher in the area of Insurance Laws and Economics, is a widely acclaimed authority on matters pertaining to Insurance, on the editorial board of several Insurance related journals and has received various best paper awards for her work in the field of Insurance.

In her research paper titled “Moral, Social, and Economic Dimensions of Insurance Claims Fraud”, published in 2008, by the Social Research Quarterly, she writes that “Customer dishonesty stems from a complex interplay of motivations and circumstances, moderated by morality, opportunity, social norms, and institutional context”.

Her research deserves mention, as the Indian insurance industry is reeling due to the pressures of various types of fraudulent claims.

Tennyson succinctly reminds us that the Insurance frauds are different from other types of frauds [shoplifting or tax avoidance] as actions of a few [fraudulent claims] result in increased premiums for everyone going forward. Also, attempts to prevent fraud by the insurance companies, lead to less protection from risks than would occur in a market without fraud. It also adds to the costs of the insurers. However, policing could lead to more fraud because it erodes the trust factor and results in more costs. Most analysts believe that the costs and prevalence of opportunistic soft fraud – particularly buildup – is much higher than those of more systematic, planned or criminal claims fraud

Therefore, prevention of fraud may be a less costly alternative. However, it requires a better understanding of the different dimensions of fraud, the determinants of consumer behaviour, and the relationship between consumer behaviour and institutional rules.

Tennyson writes that much of the Insurance claims go undetected and it is difficult to estimate the number of fraudulent activities or the amount of excessive claims.

Moral hazard is an important psychological aspect of Insurance. Having Insurance reduces the insured’s incentives to prevent losses, and exaggerated or fictitious claims. Also, customers who feel that insurance companies treat customers unfairly / make too much money / charge unfair premiums, are more accepting of fraud. Evidence also suggests that consumers will be more willing to commit fraud if they perceive that the harm to others would be small.

Probability of detection, risk aversion, sensitivity to reputation penalties, social stigma, psychic costs of engaging in fraud, social norms in the form of peer group or network influences etc. are some of the deterrents to committing fraud.

Efforts to reduce prevalence and acceptability of fraud improve image of insurance industry and enhance trust between insurers and customers. General insurance education improves the knowledge of insurance as well as results in more positive attitudes toward insurance institutions. Also, fraud public awareness campaigns may also be effective.

Evidence suggests that:

a.       Extent of fraudulent claiming is very positively related to the percentage of consumers who find claims fraud to be acceptable

b.      Attitudes vary from urban to rural, women to men, elderly to young. Women, highly educated and the elderly are likely to be less accepting of fraud

c.       Consumers with more insurance experience (more policies and more claims) are less accepting of insurance fraud

d.      Moral-psychological factors in the form of ethical thinking etc impact the fraud acceptance among the survey respondents             

Trend over the years

a.       Increased attention, more empirical studies, antifraud watchdog and advocacy groups, awareness campaigns, stronger laws

b.      Much of the focus has been directed toward detecting and criminalizing fraud

c.       Fraud awareness campaigns often emphasize the criminal nature of fraud and the likelihood of being caught and penalized

d.      Success in fighting fraud is often measured by number of cases brought or convictions obtained

e.      Increasing willingness on the part of insurers to litigate fraud and refer cases to law enforcement agencies

Opportunistic soft fraud

a.       Widely believed to be much more prevalent than criminal fraud

b.      Improving fraud detection and advertising this fact may provide an effective deterrent

c.       Many consumers do not view some forms of claims exaggeration as fraudulent

d.      A criminal focus applied to these cases may reinforce negative perceptions of insurance institutions and their fairness to customers

When internal monitors are primed, most customers state that insurance fraud (even minor claims exaggeration) is unacceptable. Consumers with more insurance experience and those with recent claims experience are less likely to believe that claims exaggeration is acceptable. Greater focus on social and psychological dimensions of insurance claims fraud may increase the success of soft fraud prevention without impairing insurance relationships.

Reference:

Tennyson, Sharon., “Moral, Social, and Economic Dimensions of Insurance Claims Fraud”, Social Research, Vol. 75, No. 4, Fraud (WINTER 2008), pp. 1181-1204