Essay About Small Investors And Agency Effect

Common Law Countries
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VIKALPA * VOLUME 36 * NO 3 * JULY – SEPTEMBER 2011 9
R E S E A R C H
includes research articles that
focus on the analysis and
resolution of managerial and
academic issues based on
analytical and empirical or case
research
Executive
Summary
Tunneling vs Agency Effect: A
Case Study of Enron and Satyam
Srinivas Shirur
KEY WORDS
Self-dealing Problem
Enron
Satyam
Bankruptcy
Unsystematic Risk
Common Law Countries
This is a comparative study of Enron and Satyam corporate frauds. An attempt has
been made to arrive at some generalizations about the key reasons for the differences
between agency and tunneling problems. Agency effect and tunneling phenomena
focus on the divergence in the interests of managers, promoters, and minority shareholders,
which are the key reasons for corporate fraud. There is a clear difference
between the fraud committed due to tunneling and agency effect. The article highlights
this feature through the case study of Enron and Satyam. The difference between
tunneling and agency effect has important implications for corporate finance. Corporate
finance is based on the assumptions of separation of ownership and management
and also perpectual continuity of corporation. If these two assumptions are dropped,
then many of the widely accepted theories may not hold.
The article concludes that the legal framework, nature of financial system, and level of
economic development are the key factors which determine the level of agency effect
and tunneling problem. Solutions to corporate governance problems are quite different
in India as compared to the US or Europe. Hence, it would be inappropriate to copy
American legislations like Sarbanes Oxley Act in India. Effective prevention of destructive
self-dealing activities is necessary for development of vibrant capital market,
whereby small investors will be confident to invest in the Indian market, since they
will perceive risk premium to be low.
The key policy prescriptions are as follows:
* Effective delivery of justice is as important as enacting investor-friendly laws.
* Creation of subsidiary companies by the parent company and large financial transactions
with banks should be viewed with suspicion. On the part of the shareholders,
they should be suspicious of any self-dealing transactions. Since the time of
Harshad Mehta, when stock brokers, promoters of the company, and bankers connived
to cheat small investors, enforcement agencies view even large banking transactions
with suspicion.
* Small investors and institutional investors should play a proactive role to seek
information and reject any decisions which reduce their value of shares. Proactive
participation of outside shareholders in the corporate affairs of the company, especially
in the selection of board of directors and approval of resolutions, are the key
remedies to prevent such cases.
* There should be an effective control of black money.
* Certain clues like promoters setting up too many subsidiaries, frequent changes
and resignations in board of directors, consistent decrease in promoter stake or
increasing liquidation of equity options, are clear signs of fraud taking place. Regulatory
authorities should work on such clues and operate in such a way that there
is least chance of regulatory arbitrage.
There is an urgent need to distinguish between companies
controlled by managers and those controlled
by promoters. Many academicians consider
agency cost and tunneling as two sides of the same
coin with the same impact on shareholders. The present
study tries to clarify this misconception. Agency cost is
prevalent in companies controlled by managers. In contrast,
tunneling is a problem faced by promoter-driven
companies. Understanding the key difference between the
two concepts is central to the future analysis of various
topics in corporate finance. This analysis is done with
the help of a comparative case study of Enron and Satyam.
Both the financial scams took place in the first decade of
the 21st century and will have wider implications than
has been understood till now.
According to La Porta, et al (1998), India and the US belong
to the common law countries which have fairly good
disclosure norms and investor protection laws.