The previous chapter presented the background and institutional framework in India. This chapter presents the theoretical framework of the study and reviews relevant literature. This starts with the discussion of agency theory. In particular, Type 2 agency costs are discussed in detail—form that prevails in family firms. The proposed framework establishes the research foundation of this study.

Agency theory

Agency theory has been extensively used by researchers in finance (Fama, 1980), economics (Spence and Zeckhauser, 1971), accounting (Fan and Wong, 2002), management (Douma, George, and Kabir, 2006; Peng and Jiang, 2010), and organizational (Schulze, Lubatkin, Dino, and Buchholtz, 2001) studies. Agency theory advanced the risk-sharing literature to account for the problem that occurs when cooperating parties have different goals (Eisenhardt, 1989). The divergence of interest between a principal and agent imposes a cost on the firm, which is commonly known as a Type 1 agency cost. Jensen and Meckling (1976) argue that agency costs are likely to decrease with the level of insider ownership and, thus, corporate performance improves with the level of insider ownership in the firm. However, Demsetz (1983) argues that an increased level of inside ownership presents a principal–principal conflict. This is called a Type 2 agency cost, which arises from the conflict between two groups of shareholders.

Entrenchment effect and convergence-of-interest arguments also suggest similar view about underlying agency costs.

Entrenchment effect: The entrenchment effect is consistent with the traditional view that family firms tend to be less efficient because concentrated ownership encourages controlling shareholders to expropriate the wealth of minority shareholders. Family members generally occupy important positions in family firms, which provide them with the power to expropriate outsiders. The family-dominated board may lack independent oversight and, thus, result in ineffective monitoring by the board. The indirect ownership obtained through cross-holdings makes the situation even worse. The controlling shareholders have greater incentives to expropriate the wealth of shareholders when they have lower cash-flow rights. Bertrand et al. (2002) provide evidence of expropriation of outsiders by controlling owners of business groups in India. Douma et al. (2006) also provide evidence of unique agency problems arising from principal–principal goal incongruence in group-affiliated firms in India.

Introduction

This chapter provides the background on the evolution of business groups and the institutional framework in India. It begins by discussing family control of business groups, followed by the facts on the evolution and transformation of these business groups. The next section looks at the Indian economy, while the fourth section provides information on the accounting standard setting process in India. The fifth section draws attention to the weak enforcement system in India, which is followed by a discussion on the rules pertaining to RPTs. The last section summarizes the main themes outlined in the chapter.

Family control

Chua, Chrisman, and Sharma (1999, 25) define a family business as ‘a business governed or/and managed on a sustainable, potentially cross-generational, basis to shape and perhaps pursue the formal or implicit vision of the business held by members of the same family or a small number of families.’

Most Indian business groups started as family businesses. They moved aggressively after Independence in 1947 and their operations became well diversified. For instance, the Birla group was established by Seth Shiv Narayan Birla in 1870 as a small cotton and jute trading business. Over the years, the group has diversified its operations into petrochemicals, textiles, telecommunications, cement, automobiles, and financial services, and the group now consists of more than 40 companies. Although each firm within the group is a separate legal entity, control still resides with the promoter families. In the case of the Birla group, Kumar Mangalam Birla, the only son of Aditya Birla, is the current chairman. Considering the nature of these business groups (family controlled), the literature on family firms would be relevant to examine the attributes of Indian business groups. The terms ‘business groups’ and ‘family firms’ will be used interchangeably in this study. Khanna and Yafeh (2007) identify that groups are generally family firms and their behaviour can be understood better from this perspective.

The literature on property rights suggests that the legal system shapes the structure of property rights. Fan and Wong (2002) view share ownership rights as property rights, with shareholders being entitled to certain rights. First, the shareholder has control rights. Second, the shareholder has cash-flow rights, and finally, the right to transfer the shares. The value of the shares depends on the enforcement of such rights. The enforcement is undertaken by the owner and the state (Fan and Wong, 2002).

Introduction

This chapter presents descriptive statistics and other preliminary statistical tests to provide insights into the ownership structure and the RPTs disclosure of sample firms. First, the descriptive statistics of the entire sample comprising 1,530 firm-year observations are presented. This is followed by division of the sample into two categories: (a) firms which have disclosed RPTs, and (b) firms which have not disclosed any RPTs. Further analysis is then conducted by dividing RPTs based on the association with the related party. RPTs with subsidiary and holding companies are separated from RPTs with other group member firms. These analytical steps provide an important overview of firm characteristics and RPT disclosure. Finally, the Pearson correlation matrix is presented to identify any potential multicollinearity problems.

Descriptive statistics of the full-sample

This section provides descriptive statistics for all research variables, including firm-specific characteristics of the sample. Independent variables consist of direct and indirect ownership of controlling shareholders, minority ownership, and the magnitude of RPTs, whereas the dependent variable is the MVE. Table 6.1 provides descriptive statistics for the full sample of 1,530 firm-year observations.

The dependent variable, MVE, has a mean value of INR 211 with a maximum value of INR 8,799 and a minimum of INR 0.42. The average book value of equity is INR 127, with a maximum value of INR 5,051 and a minimum of INR -497. Average earnings per share amount to INR 20 and median earnings are INR 7, with a maximum of INR 1,436 and a minimum of INR -1,297. Average direct ownership of controlling families (DIROWN) amounts to 15 per cent only, with a median ownership level of 7 per cent. Indirect ownership of controlling families (INDOWN) averages 34 per cent of the total ownership, with a maximum value of 88 per cent and a minimum ownership level of zero. The minimum value of zero represents no indirect ownership, which suggests that such firms are controlled through direct ownership only. The results suggest that the proportion of indirect ownership through cross-holding is significantly higher than direct ownership, as the average holding of indirect ownership is more than double the proportion of direct ownership. This explains the prominence of cross-holdings in the context of the study. The average shareholding of minority shareholders with minimal holding (MINORITY1) is 16 per cent, whereas the average shareholding of minority shareholders with significant holding (MINORITY2) is 5 per cent.

This last chapter discusses the key findings, the implications of the research findings, avenues for future research, and provides concluding remarks. The coverage begins with a summary of the key findings followed by the discussion on the implications of this study. The next section highlights the contributions of the study. The last section provides directions for future research and concluding remarks.

Key findings

One of the most important challenges to the governance structure of family-controlled firms is to limit controlling shareholders from extracting private benefits at the cost of the minority shareholders. This study investigates the influence of ownership structure on the MVE in Indian business groups. As for firm-level ownership structure, the study considers three main features: (a) direct ownership of controlling shareholders; (b) indirect ownership of controlling shareholders, and (c) minority ownership. Moreover, the use of RPTs as a means of entrenchment is examined.

Given the importance of principal–principal conflict in family-controlled firms, this study seeks to address those issues by providing answers to several critical questions. Table 9.1 highlights the key research questions and main findings of the study.

The finding of a non-linear association between the indirect ownership rights and firm value is broadly in agreement with the view that indirect ownership is employed as a vehicle by controlling families to extract private benefits in India. Bertrand et al. (2002) and Douma et al. (2006) critically analyse the role of cross-holding in group-affiliated firms. RPTs affect firm value negatively, especially in the presence of indirect ownership rights of the controlling shareholders. This finding raises questions on inadequate regulations pertaining to RPTs. OECD (2012) also raises concerns over inadequate regulatory requirements pertaining to RPTs and the role of independent directors in approving such transactions. Such concerns have led to significant changes under the Companies Act, 2013 and SEBI Listing Requirements, which include shareholder approval for all material RPTs and the availability of an e-voting facility for all shareholder resolutions.

This chapter presents a detailed discussion of the research methods used in the study. This chapter is organized as follows. The first section explains the procedures employed to select the data sample. The next section provides the description of the data, which includes the selection of firms based on group membership and industry classification. The last section explains the empirical models employed to measure the valuation of the effects of group membership, ownership structure, and RPTs.

Sampling procedures

Sample selection

The Prowess database developed by the Centre of Monitoring Indian Economy (CMIE) is used to identify the sample firms. We identify two parameters to select firms for the analysis. These are: (a) firms belonging to Indian Business Groups, and (b) firms that are listed on the BSE. On 20 November 2012, the initial search using the Prowess database identified 8,420 group firms, of which, only 1,640 firms were found to be listed. As financial firms are subject to different regulation, we chose to exclude financial firms from the sample. After excluding them, 1,443 firms remained. We randomly selected 400 firms from them. The data we require for the analysis (financial, ownership, and corporate governance) was not available for all 400 firms. There were 83 firms with missing information in the Prowess database. After deleting those firms from the sample, there were 317 firms, which is approximately 22 per cent of the total population (1,443 firms). The details of sample firms are provided in Panel A of Table 5.1. Appendix 1 provides names of firms included in the sample. Information on RPTs and corporate governance is hand collected.

Total sample firms belong to 156 business groups. The average firms per group is two, with a minimum of one firm per group and a maximum of eight firms per group. Appendix 2 provides the names of these groups and the number of firms per group.

We examine the group firm ownership structure and RPTs for sample firms for the recent five-year period from the year ending in March 2008 to March 2012. Our sample contains 1,530 firm-year observations. The number of individual year observations varies because of missing variables for some firms in particular years during the selected period and details are provided in Table 5.1 (Panel B).