Governance in failed enterprise: Not a simple situation

V G Siddhartha’s passing away is a tragic end for a gentleman who made a lot happen in the country over coffee. May his soul rest in peace.

The episode has brought to surface several issues, including the harshness of the tax authorities or their inability to delink entrepreneurship from business failure. This may, therefore, be the right time to take stock of certain issues associated with Indian entrepreneurship model in general.

Are the tax authorities excessively harsh? On the contrary, it is probably because Indian tax authorities were historically rather timid and lax — given the role of power-distance index in dealing with the land’s rich and the powerful — that enormous black money was being generated by the rich and the powerful. It is perhaps for the first time that a government is taking swift and tough actions against some industrialists and businessmen. Little surprise that their friends and well-wishers — some genuinely, and others perceiving an opportunity for deflecting their own shenanigans (for instance, even Vijay Mallya has accused the government of tax terrorism) — are crying foul.

Those accusing our tax authorities of being unduly tough, perhaps, do not realise that in comparison to the IRS of the United States, our taxmen are like Mother Teresa.

As to delinking entrepreneurship from business failure, consider some of the business houses in recent times that have been severely stressed — in the red from Rs 10,000 crore to Rs 100,000 crore — (in alphabetic order): Bhushan Steel, DHFL, DLF, Jet Airways, Essar Group, ESSEL, Gitanjali Group, ILFS, JayPee, Kingfisher, Ranbaxy, Reliance ADAG, Sun Pharma, Sterling Biotech, Videocon, Zee Entertainment. And let us not forget the mismanagement in some of our largest banks, infrastructure and power companies, all of whom together have cost our banks lakhs of crores (Rs 10 lakh crore according to some). This is mostly the common man’s money in banks.

Have each of these been strictly a business failure, with none of them having been run aground through mismanagement, poor corporate governance or even outright fraud, even as the promoters enriched themselves enormously? And yet, exactly which of the entrepreneurs associated with the above companies been hounded by the income tax authorities unjustly? If not for personal wealth accumulation even as businesses failed, how is it that many of the entrepreneurs try to bid for their bankrupt enterprises when they are auctioned?

We should recognise that a polite tax raid in India where black money accumulation attaches little social condemnation, is hardly likely to be effective among habitual tax-evaders who follow a certain set pattern. Here is a simplified primer, in many cases, if not all:

Difficulty of doing business in India essentially stems from the extreme national corruption which ups the cost of a project anywhere from 30-40 %. This means a project worth Rs 1,000 crore now costs up to Rs 1,300 crore because of the kick-backs to be paid. If a project worth Rs 1,000 crore yields a viable return on investment (ROI) of 14%, because of corruption, the project cost goes up to Rs 1,300 crore and the ROI drops to about 11%, impairing the viability of the project. If the project involves an IPO, the market price drops and the minority shareholders take a haircut.

But how do entrepreneurs generate the extra Rs 300 crore or Rs 400 crore required for lining the pockets of politicians and babus? By over-invoicing the project costs. But that’s not all. The entrepreneur feels foolish generating Rs 300-400 crore for the politicians and babus and not use the same route to wet their own beaks somewhat. So they over-invoice — not to the extent of 30% — but maybe 45%. This also subsidises the entrepreneur’s own share of equity that he is supposed to bring into the project.

So now the project cost is up to Rs 1,450 crore and the ROI falls to 9.5% and the share price drops further. While the supplier ships equipment worth say Rs 1,000 crore, the business makes a payment of Rs 1,450 crore to the supplier of which the supplier has already agreed to transfer Rs 300 crore into the numbered accounts of politicians (in the name of collection for their parties) and Rs 150 crore into the account of the entrepreneur. As the size of a company grows, the overseas bank balances into the numbered accounts of the entrepreneurs keeps growing, some of which even come back as foreign direct investment.

This means risk of entrepreneurship is in fact low in India, because the real stake of entrepreneurs in their enterprises is actually much lower than what is shown in the books. So in accordance with the principles of Principal-Agency Conflict, the entrepreneur borrows heavily, because loans carry a fixed cost (interest), unlike equity. So, if the businesses per chance make big profits, the entrepreneurs enjoy their good fortune and can pay off the debt. But if the business loses money, the can is to be carried by the banks as NPAs; they have relatively little to lose, as their real stakes have been siphoned away. In addition, they also spend recklessly, pay themselves huge salaries and charge all their personal expenses whether planes, boats, expensive cars or first-class flying, 7-star holidays, as business expenses, because for every rupee that they spend, their own share may be less than 15 paise!

This is not to say there are no honest or relatively honest groups and companies. There are many, especially among the new-age entrepreneurs, who have created genuine wealth and shown the country the art of giving. And such companies are of course seldom in news for the wrong reasons.

Lastly, the intent of this article is not to blame the entrepreneurs for all the ills in our economy. While many are victims of systemic corruption, many others are active and willing participants in it, which calls for reforms at a very different level. But that is a topic for a different article.

(The writer is Director, Schulich School of Business, India Programme)