This article gives an in depth analysis on Evolution Of Corporate Governance In India & It's Influence On India's Capital Market. It has been co- authored by Dr. Uday Salunkhe, Director of the prestigious Welingkar Institute of Management and Research.

1. Evolution Of Corporate Governance In
India & It's Influence On India's Capital
Market
Prof. (Dr.) Uday Salunkhe, Prof. (Dr.) P.S. Rao, and
Prof. Amitha Sehgal
Abstract
In recent years the issue of corporate governance and the design of appropriate governance
mechanisms have become important subjects of academic research and policy discourse in
both developed and developing countries. The increasing importance of governance
mechanisms comes in the wake of major corporate scandals in internationally renowned
companies like Enron , Tyco and Worldcom as well as East Asian crisis in the early nineties and
Satyam in India, with a large body of empirical and theoretical research highlighting the
significant impact that an economy's corporate governance system can have on the
profitability and growth of corporations.
Corporate governance is now increasingly being recognized as a crucial instrument to
improve the efficiency of companies and to enhance the investment climate in a country.
This paper traces the history of India's stock market and the impact of corporate
governance norms on its evolution and growth.
KEY WORDS: Capital markets, India's Economic Liberalisation, Corporate Governance.
1.1 Understanding the meaning of corporate governance
Recent corporate scandals have focused attention on corporate
governance for all the wrong reasons. There is a need to cut through all the
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2. sensational corporate governance failures, like the case of Satyam, to
understand what is the meaning of corporate governance.
Shleifer and Vishny state that "Corporate governance deals with the ways
in which suppliers of finance to corporations assure themselves of getting
a return on their investment ." (1997, p.737).
Corporate governance in the Indian context spells out clearly that ethics
and values form the bases of corporate governance, while adherence to
the legal framework is the minimum requirement. Confederation of Indian
Industries (CII) - Desirable Corporate Governance Code (1998) defines it as
"Corporate Governance deals with laws, procedures, practices and implicit
rules that determine a company's ability to take informed managerial
decisions vis-à-vis its claimants - in particular its shareholders, creditors,
customers, the State and employees. There is a global consensus about the
objective of 'good' corporate governance: maximizing long-term
shareholder value."
"Corporate Governance is an art of managing companies ethically and
efficiently for enhancing stakeholders' value.
The entire gamut of corporate governance system could be referred to as
"corporate ethical and values system".
(extracted from the Report of the Committee on the Companies Bill, 1997).
The Narayana Murthy report, (2003) has a comprehensive definition :
"Corporate governance is the acceptance by management of the
inalienable rights of shareholders as the true owners of the corporation
and of their own role as trustees on behalf of the shareholders. It is about
commitment to values, about ethical business conduct and about making
a distinction between personal and corporate funds in the management
of a company".
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3. These definitions reflect the Indian ethos of corporate governance as
articulated by Mahatma Gandhi in his writings. He believed that
management is a trustee of shareholders capital and business is a trustee
of all resources, including the environment. As trustees the primary goal of
management is to protect the interest of the owners and also, not to exploit
resources for short term profits.
In India, the initiative on corporate governance was not a result of any
major corporate scandal, like Enron, World Com, etc. It started as a self-
regulatory move from the industry rather than the rule of law.
The earliest developments in India began in 1991, after the report of the
Cadbury Committee was released in the U.K. Industry groups held seminars
and conferences to discuss the Cadbury report and its relevance to India.
The Confederation of Indian Industries (CII) was the first to introduce a
code on corporate governance in April 1998. Some companies did comply
with the same in their annual reports of 1998-99. It was voluntary in nature.
Over the years, the Government of India and the Securities and Exchange
Board of India (SEBI) have constituted several committees to make
recommendations. Recommendations of three landmark committee
reports are milestones in the journey towards better governance.
The Kumar Mangalam Birla Committee (1999), constituted by SEBI was
instrumental in the addition of a new Clause 49 to the listing agreement
with the Stock Exchanges. This was a landmark in the history of corporate
governance in India. These recommendations, aimed at improving the
standards of Corporate Governance, are divided into 19 mandatory and 6
non-mandatory recommendations.
Its major contribution was in recommending the constitution of the Board
of Directors (specifying the minimum number of independent directors
and board procedures); the Audit Committee (including the mandatory
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4. requirement of an audit committee); Disclosures (mandatory Management
Discussion and Analysis section in Annual Reports + other disclosures). For
the first time in the history of corporate India, specific corporate governance
processes and disclosures were mandated under the listing agreement with
the stock exchanges.
This was followed by the Naresh Chandra Committee on Corporate Audit
and Governance in 2002. The committee recommended best practices
regarding the statutory relationship between auditors and companies and
set the highest standards for the role of audit committees. For example,
Clause 49 has incorporated the recommendation of the Birla Committee
that the audit committee should have three non-executive directors as
members with at least two independent directors, and the chairman of the
committee should be an independent director.
But the Naresh Chandra report set the benchmark higher. It recommended
that all members of the audit committee should be independent directors,
thereby plugging the loophole that could make it possible for a promoter-
director without an executive role in the company becoming a member of
the audit committee.
Progressive companies like Infosys follow the benchmark spelt out by the
Chandra report and all the members of its audit committee are independent
directors.
The N.R.Narayana Murthy Committee (2003), raised the bar with greater
emphasis on internal controls and risk management systems in companies.
Several of its recommendations, concerning related party transactions and
qualifications of audit committee members were accepted by SEBI and
made mandatory under Clause 49. Interestingly, the committee made an
important non-mandatory recommendation that companies must be
encouraged to move towards a regime of unqualified financial statements
(In many cases auditors taint financial statements with their disapproval/
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5. objection to some of the accounting practices). This recommendation has
not yet been accepted.
All these progressive developments in improving corporate governance
have vastly improved the equity/capital market climate in India.
The primary purpose of corporate governance norms is to ensure that
managers protect the investment of the owners (scores of minority
shareholders of the company's stock) and maximize their returns on such
investment. Since the stock markets are the conduit through which these
investments are made, the mechanics of the stock market and the principles
of corporate governance are enmeshed in a continual cycle of co-
dependency.
The goal of this research paper is to understand the evolution of corporate
governance in India, against the backdrop of the history of India's stock
market, its corporate culture and the government attitude that strongly
influenced the way business was conducted. It traces how corporate
governance has evolved in India, from the time of India's independence
till date. It also attempts to assess how new listing norms under Clause 49
issued by the Securities and Exchange Board of India and other regulatory
reforms impact the functioning of the Indian stock markets.
Several recent measures taken to reform liberalize the Indian business/
banking environment and simultaneously introduce sound corporate
governance practices, have helped create robust stock markets, which in
turn have raised the standards of corporate governance.
1.2 Early Developments In India
Traditionally, dominant promoter groups and lax oversight by debt
providers have been the underlying weakness of corporate governance in
India.
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6. This has led to weak company boards, inept institutional activism and,
therefore, poor protection of minority shareholders. Though India has not
experienced large scale corporate scandals like those experienced by the
U.S., this is more a result of a convergence of the interest of management
and owners (both constituted by the dominant promoter-family/dominant
government holding), rather than because of higher standards of corporate
governance.
But, in this context, it is crucial to understand how India's culture and
political orientation were disincentives for higher governance standards.
The idealism of socialism and equitable distribution of wealth formed the
basis of a very high tax structure - both personal/corporate and also wealth
tax.
Companies had no incentive to show higher profits on their books and
enhance shareholder value. Simultaneously such high taxes encouraged
the growth of a strong parallel black economy. The private sector was denied
access to the equity market at fair market valuations due to strict control of
the pricing of public issues by the erstwhile Comptroller of Capital Issues.
The combination of high taxes and low valuations left no incentive for
good corporate governance.
1.3 The Corporate Governance Model
While corporate governance in India is modeled on the lines of the
Anglo-American system, (with an emphasis on shareholder protection),
with definite elements inspired by the German-Japanese system, (with its
emphasis on protecting all stakeholders); its chief concern has, through
the decades, remained unique.
1.3.1. Theory of the Firm & the Agency Problem
The fundamental basis of corporate governance is agency costs.
Shareholders are the owners of the limited-liability company and are the
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7. principals. The managers appointed by the shareholders, directly or
indirectly are the agents. Shareholders surrender the management of the
company to professional managers (agents), with the hope that they will
protect their interests. Agency problems occur when the principal
(shareholders) lacks the necessary power or information to monitor and
control the agents (managers) and when objectives of the principal and
the agents are not aligned. The extent of misalignment of objectives
between the principal and agents measures the agency costs. The goal of
corporate governance is to reduce this agency costs.
This can be expressed diagrammatically as follows :
The impact of the agency problem differs depending upon the ownership
structure and whether it gives shareholders direct control over
management.
In the Indian context we have five different structures and the impact of
agency costs varies for each of them.
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8. l Highly Dispersed Shareholding and professional management (Very
few in number. e.g.: L&T, ICICI Bank, Infosys).
l Concentrated Ownership and management control rests with majority
shareholders, mainly in family managed companies (The dominant
structure. e.g.: Grasim, Hindalco, Reliance Industries, Wipro).
l Public Sector with government ownership and professional
management (Another dominant structure representing around 30
per cent of India's market capitalization. E.g.: State Bank of India, ONGC,
BHEL).
l Multinational Corporations (Hindustan Unilever, Colgate, Siemens).
l Family Ownership but professional management. (Very few in number:
Exide, Eicher).
The Anglo-American model, with widely dispersed shareholding in the
United States fundamentally addresses the "Principal-Agency" conflict
issue. It attempts to resolve the conflict of interest between management
(agents) and shareholders (principals). While this conflict is a concern in
India, the predominant issue in India is the conflict between "dominant"
shareholder-promoter groups and minority shareholders.
Illustrating this, is the Discussion Paper (February 8, 2008) by the Finance
Ministry that seeks to revisit the provisions of the Securities Contract
(Regulation) Rules (SCRR).
The paper revolves around the need to increase the mandatory minimum
public holding to 25 per cent, from the existing 10 per cent, in a limited-
liability firm listed for public trading on the stock market. This would apply
to Initial Public Offers (IPOs) as well as already traded companies. Also, it
would equally apply to a government company and a private company.
Interestingly, this is the first time that regulators propose to define "public"
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9. in terms of its literal meaning of people at large. The Discussion Paper notes
that since the word "public" has not been defined so far, it could mean
"non-promoters" and include financial institutions, foreign institutional
investors, mutual funds, employees, NRIs/OCBs, private corporate bodies,
etc, thus making the floating stock insignificant.
There are around 250 big and small listed companies with promoter holding
of over 75 per cent each. The prominent among them are Wipro, Tata
Consultancy Services, Jet Airways, DLF, Puravankara Projects, Akruti City,
Omaxe, Plethico Pharmaceuticals, Sobha Developers, Mundra Port, BGR
Energy, Blue Dart, Parsvnath Developers, and Bosch Chassis. The promoters,
in most cases, currently hold over an 80 per cent stake in these companies.
Table 1.11: Public Shareholding in select CompaniesA clear definition of
the word "public" will also restrict the growing dominance of Foreign
Institutional Investors.
1
Source : Business Standard, February 8, 2008.
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10. A case in point is the IT industry. Promoter and promoter group stakes in
India's top five IT services exporters TCS, Infosys, Wipro, Satyam and HCL
Technologies have come down between FY2005 and FY2007, even as these
companies chart an aggressive roadmap to expand global footprint.
Over the last three years, these companies witnessed a decline in their
promoter group holding, and some of them saw the Foreign Institutional
Investor (FII) holdings going up. The decline was steep - in excess of five
percentage points in case of Infosys and Satyam, while it was a little over
three percentage points in case of TCS, Wipro and HCL. The decline in Infosys
is due to the company's sponsored secondary ADS (American Depository
Shares) offers during these years, wherein promoters diluted their holdings
to a certain extent. Infosys' two sponsored secondary ADS offerings - in
May 2005 and November 2006 - saw its overseas float increase to 19 per
cent.
Table1.22 : Falling Stake of promoters
(in per cent)
March 2005 March 2006 March 2007
TCS 84.84 83.69 81.65
Infosys 21.76 19.50 16.54
Wipro 83.11 81.44 79.58
Satyam 15.67 14.02 8.79
HCL Tecno 70.67 69.44 67.55
Though the non-promoters holding is about 48%, the public held only
15.26% and the institutional holdings by (FIIs, MFs, FIs) accounted for
20.67%. There is not much significant difference in the shareholding pattern
of companies in different sectors. About 80% of shares in companies in
infrastructure sector are held by Indian promoters. The German/Japanese
model of corporate governance allows for a close relationship between
banks/financial institutions and companies. It is also characterized by large
cross-holdings between companies.
2
Source : Kulkarni V. and Chatterjee, M.B., Hindu Business Line August 11, 2007
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11. Similarly, in the years prior to 1991, Indian companies had limited access to
the equity markets and were largely dependent on banks and Financial
Institutions (FIs) for their funds (see Table 3).
Table 1.3 : Pattern of Sources of Funds for Indian Corporate
Percent of total
1985-86 to 1990-91 to 1995-96 to 1999- 2000-01 to 2004-
Item
1. Internal Sources 31.9 29.9 37.1 60.7
2. External Sources of which: 68.1 70.1 62.9 39.3
a. Equity capital 7.2 18.8 13 9.9
b. Borrowings of which: 37.9 32.7 35.9 11.5
i. Debentures 11 7.1 5.6 -1.3
ii. From Banks 13.6 8.2 12.3 18.4
iii. From FIs 8.7 10.3 9 -1.8
c. Trade dues & other current liabilities 22.8 18.4 13.7 17.3
Total 100 100 100 100
Note: Data pertain to a sample of non -government non -financial public limited
companies.
3 Source : Article on "Finances of Public Limited Companies", RBI Bulletin (various issues)
But unlike in Japan/Germany, where banks play a critical role, as creditors,
in the corporate governance of companies, in India, though banks/ FIs had
large debt exposures to the Indian corporate sector, (and with a conversion
clause in the loan agreement the debt was often converted into an equity
holding) several studies have shown that they did not exercise close
monitoring of the corporate governance standards in these companies.
An analysis of the above table clearly shows that the proportion of funds
from internal sources started increasing from 1995-96 onwards, after
economic reforms started and after wealth tax was abolished. Wealth tax
was payable on dividend income post tax, which was insufficient to pay
the onerous wealth tax, leading to a dilution of management holding in
order simply to pay it. Its abolition, therefore, gave every incentive to
promoter management to retain profits in companies instead of siphoning
it out.
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12. It is observed that in the Indian context, the external market exercises a
limited force on corporate governance (since the floating stock in the
secondary market is limited). Nor is the internal force of a strong Board
(since management and Board members are, very often, from the same
dominant promoter group) always effective in protecting the principles of
sound corporate governance.
Despite globalization, and an increase in foreign institutional investment
in Indian companies, institutional activism is also weak and yet to emerge
as a strong counter force. Institutional investors, both domestic and foreign,
are more prone to vote with their feet, by exiting the stock, than to influence
a change in management behavior.
The onus of protecting the interest of minority shareholders and other
stakeholders, thereby ensuring high standards of corporate governance,
falls primarily on the market regulator, Securities and Exchange Board of
India, Reserve Bank of India, the Department of Company Affairs,
Government of India, the media, both print and electronic, and the stock
exchanges.
1.4 A Historical Perspective: Early Years After India's Independence
On gaining independence in 1947, India's first Prime Minister, Jawaharalal
Nehru, emphasized the need for the country to build heavy industry (steel,
cement, capital goods) and the primacy of the role of the public sector in it.
The corporate sector had inherited a managing agency structure that was
stacked in favor of managing agents. The first managing agency in India
was British. It was established in 1809. Carr, Tagore & Company is known as
the first equal partnership between European and Indian businesses and it
also initiated the managing agency system in India.
From then on, for over a century, growth of joint stock companies and
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13. managing agencies was simultaneous and it was dominated by the power
and influence of the managing agencies.
In 1850, an Act was passed for the registration of companies with limited
liability. It marked a turning point in the history of Indian business. Agency
houses formed new joint stock companies, to attract savings from a large
pool of investors. The managing agents controlled these companies
through inter-locking of directorship and inter corporate investments.
Several malpractices and speculative trends emerged on the Bombay and
Ahmedabad stock exchanges. This system dominated Indian business till
independence. It was formally abolished in 1969.
Indian business families continued the controlling streak that the managing
agency system had put into place. In 1950-51, for example, 9 leading Indian
industrial families held 600 directorships, with only two families, viz. Dalmia
and Singhania holding 200 of them. One hundred individuals were found
to hold 1700 directorships, 30 of them holding 860 directorships and the
top 10 held 400 directorships.
The practice of multiple directorships continued to plague Indian corporate
boards. The Bhabha Committee (1953-54) recommended as upper limit of
20 directorships.
This was incorporated in the Companies Act, 1956. Ram Jethmalani, the
law minister in the Union Government (1996-2000), specified the maximum
number of directorships to be 15, the limit that continues till date. Dr. JJ
Irani Report on Amendments to the Company's Act (2005), has also
recommended 15 as the maximum number of directorships.
In 1964, the Monopolies Inquiry Commission (MIC) was appointed to look
into the concentration of ownership in industry. MIC concluded that the
overall concentration of industrial power had increased since 1950.
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14. Professor RK Hazari Committee Report (1966) and Dutt Committee or the
Industrial Licensing Policy Inquiry Committee (1969), laid the framework
for the passing of the Monopolies and Restrictive Trade Practices (MRTP)
Act in 1970.
This restricted the size and scope of private enterprise. In 1977 it became
mandatory for the All India Financial Institutions to put the convertibility
clause and nominee directors' appointment clause in their loan agreements.
After the second phase of bank nationalizations (the first was in 1969) in
1980, all major banks and all large financial institutions were in the public
sector. The stage was set for the Government to have a firm grip on, and a
substantial stake in, both the industrial sector and the financial sector.
Government kept out of stock markets; up until the advent of the National
Stock Exchange (NSE) in 1992, it was the Bombay Stock Exchange (BSE), a
130 year old exchange, which was the major exchange for companies to
list their shares on. The BSE was governed by brokers as a self regulatory
organization. There were other, minor, regional exchanges which have died,
or are dying, a natural death.
1.4.1. Role of Private Sector
The private sector had a small role to play in industrial development
and had to rely, largely, on financial institutions for their funding
requirement. Although India boasts of having one of the oldest stock
exchanges in the world, its equity market had yet to mature for several
reasons.
Primarily, the offer price for new issuances was not market determined but
was based on a formula determined by a Government functionary called
the Controller of Capital Issues (CCI). It used an average of the past three
years high/low stock prices, the book value and the earning value of its
stream of profits capitalized at an assumed rate, to determine at what price
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15. stock could be issued. In essence, historical, rather than prospective,
earnings were the determinants.
Thus the private sector was denied access to the equity market except at
prices so low that there was no incentive for good corporate governance. It
had to rely on debt funding from the six All India financial institutions for
project finance, and from public sector banks for its working capital finance.
Both came with a price tag.
Bank loans for working capital were expensive whereas the rupee loans
from all India financial institutions carried with them an option to convert
a fifth of the loan into equity at very attractive prices.
Hence in the context of how financial markets were then structured, and in
the prevailing ethos of domination of the public sector, good corporate
governance was of the least importance for management. There was no
reward for good governance. Industrial enterprise was licensed and simply
obtaining a license to manufacture anything was almost enough to assure
a profit. Licensing restrained domestic competition and high tariff walls
ensured that there was no foreign competition either.
In short, the interest of shareholders became subservient to the interest of
lenders, which were in the public sector and which permitted, even
encouraged, a high leverage. A debt: equity ratio of 3:1 (or more) was fairly
common, and high profit margins for producers, due to a lack of
competition, allowed such high leverage.
The interest of the customer became subservient to the fiscal interest of a
Government that got a good chunk of its revenue from high import duties.
Corporate governance thus did not necessitate finding ways to enhance
shareholder value nor did it involve customer care. The reasons were simple.
Shareholder value was, in fact, sought to be contained, because not only
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16. were income tax rates were very high (going up to 97 per cent) but there
was also a wealth tax payable on such holdings. Dividend income, after
paying tax, did not leave enough for the wealth tax, resulting in a dilution
of holding by promoter groups. Simultaneously, because of the option to
convert rupee loans, the share of the six all India financial institutions was
increasing. This, of course, alarmed the private industrial groups.
The biggest tax breaks were on capital investments including depreciation
and allowances for setting shop in 'backward areas' where Government
wanted industrial development and job growth and gave fiscal benefits to
achieve it. This, of course, led to a scramble for licenses to invest and
applications to finance the projects to the monopolistic all India
institutions. Rupee loans from domestic financial institutions came, of
course, with a Damocles sword of conversion option into equity.
This structure of financing of industry led to several consequences. Poor
quality of goods to consumers for one, and mediocre returns to equity
investors, for another. There was a time when the wait for a telephone
connection (a monopoly of MTNL in metros and BSNL outside of them;
both Government companies) or of scooters (a near monopoly of private
sector Bajaj Auto) was of several years.
The quality of service or product was awful but given the absence of any
alternative supply source, Indian consumers accepted these with stoicism,
in conformity with the Hindu philosophy of 'karma'. Corporate governance
was thus restricted to producing more since this assured a profit irrespective
of quality.
Investors were content with investing in debt instruments of the
Government of India, which yielded decent returns after factoring in
inflation. Investor queries to management at annual meetings of
shareholders tended to focus more on why dividend was not increased or
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17. why bonus shares were not issued, than on the nature of business or the
quality of management. Corporate governance was, largely, cozy meetings
of closed groups of associates. Director fees were governed by the Centre
and were not conducive to encouraging an independent spirit of inquiry.
The structure also led to poor productivity and lack of innovation, there
was simply no incentive to do either to survive, in the absence of
competition. The equity market, though old, had not created enough
excitement to the number of investors willing to take its risk.
This excitement came about in 1973 when a minister, George Fernandes,
gave transnational companies operating in India an ultimatum. Either offer
40% of your shares to domestic investors or quit. Two companies, IBM and
Coca Cola chose to quit (only to return later); the rest diluted and so created
community interest in their prosperity.
Because the offer price of these issues (these companies were called FERA
companies since they were covered by the Foreign Exchange Regulation
Act) was controlled by the CCI formula, resulting in a low price, allotment
of shares in them was a safe and splendid investment. The FERA dilution
gave a major impetus to equity investment and thousands of new investors
were attracted to stock markets.
But Government policies still stilted in favour of "public good" and
macroeconomic considerations, rather than encouraging private
competition. One such policy introduced during the aftermath of the
Bangladesh war (1971) to curb inflation, was introduced by the then Prime
Minister, Indira Gandhi, was control on dividend, by the introduction of
Companies Dividends Restriction Ordinance in 1974, further dampening
the development of the capital market.
The structure of a protected market providing enough margin to sustain a
highly leveraged industrial sector at high financing cost, broke down in
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18. 1991. India went into a financial crisis, with enough foreign exchange to
support just two weeks of imports. Manmohan Singh, as Finance Minister,
supported by the taciturn Narasimha Rao as Prime Minister, saw the writing
on the wall. He ushered in economic liberalisation.
Import tariffs were slashed and licensing requirements greatly reduced.
This ensured competition from both imported goods as well as domestically
produced ones. In order to protect Indian industry from an onslaught of
imports and to give them time to prepare themselves, he did two things.
One was a sharp devaluation of the rupee. The other was to bring down
import duty in steps. He then did a third thing, which was to open capital
markets to foreign investors.
1.4.2 Liberalisation Blues
Even as the economic reforms ushered a transformation in India's corporate
sector, investors had to carry the baggage of poor governance and lax
regulation, into the next phase of India's economic history.
The first jolt was the Harshad Mehta securities scam in 1992, involving
several banks. (Harshad Mehta was an aggressive bull operator in the
Bombay Stock Exchange). The stock market crashed by 40 per cent, in the
two months after April, 1991 when the media exposed the story, with a loss
of around Rs.1,00,000 crores.
This was followed by several cases in 1993 when transnational companies,
seeing the "India growth story", started consolidating their ownership by
issuing equity allotments to their respective controlling groups at steep
discount to their market price. In this preferential allotment scam alone
investors lost roughly Rs.5000 crore.
The third scandal was the disappearance of companies during 1993-94.
Between July 1993 and September 1994, the stock market index shot up by
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19. 120 per cent. During this boom, 3,911 companies that raised over Rs.25,000
crore vanished or did not set up their projects. The case of vanishing
companies continues to persist. The issue is monitored by the Department
of Company Affairs and not by SEBI or the stock exchanges, and there are
regulatory shortcomings that have failed to plug this issue.
Recently, a high powered Central Coordination and Monitoring Committee,
co-chaired by the Secretary, Department of Company Affairs and Chairman,
SEBI was set up to monitor action taken against vanishing companies. It
was decided to set up seven task forces at Mumbai, Delhi, Chennai, Kolkata,
Ahmedabad, Bangalore and Hyderabad with Regional Directors/Registrar
of Companies of the respective regions as convenor, and regional offices
of SEBI and stock exchanges as members. Their main task would be
identifying companies which have disappeared, or have misutilised funds
mobilized from investors, and to suggest appropriate action as per the
Companies Act or SEBI Act.
Another scam involved the plantation companies in 1995-96. It saw around
Rs.50,000 crore of retail investor money disappear.
Ketan Pareikh, a major bull broker, propelled the information technology,
communications and entertainment stocks to dazzling heights from 1999
onwards till the crash in 2001, when his speculative trades were exposed
and the market crashed 177 points.
Prior to 1991, the only mutual fund then was in the public sector, in the
form of the Unit Trust of India (UTI), one of the six all India financial
institutions. Its governance was, by virtue of Government ownership, at its
sole discretion. Its flagship scheme was the US 64 scheme, which ended up,
several years later, in deep trouble, because of bad governance.
US 64 (a mutual fund product launched by UTI) started, like all open ended
mutual funds, as an open ended scheme, with redemptions and purchases
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20. linked to net asset value (NAV). NAV linked redemptions impose their own
discipline on investing; if investors do not like the performance, they exit. It
was a regular income scheme (it had to invest around 80 per cent in debt
instruments) but it changed its investment portfolio and by the late 1990s,
70 per cent of its portfolio was in equity.
The crash of the stock market in 2001 saw its portfolio value crashing. US
64's position became untenable, and the fund announced that it would
drop its repurchase price to Rs 10, to the consternation of those who had
bought units at Rs. 16 in the recent past. Investor confidence was shaken
and the Government bailed out UTI, taking over (at reduced liability) the
assets and liabilities of US 64and segregating and spinning off the other
assets.
The UTI episode shook the confidence of the small investors. There was an
urgent need felt to reform India's capital markets. Though the Securities
and Exchange Board of India was established in 1988, it was empowered as
a capital market regulator in 1992 (post-Harshad Mehta scam), with the
passing of an Ordinance, giving it statutory status and powers. Since then,
SEBI had taken several steps to reform the market. But after the UTI episode
it had to tackle a confidence-crisis that hit the equity market on a war
footing.
1.5 Reforms in India's Capital Markets
Among the first steps taken by the government was to repeal Capital Issues
(Control) Act, 1947, in 1992 paving the way for market forces in the
determination of pricing of issues and allocation of resources for competing
uses. Companies were free to price their issues according to what investors
perceived to be their value, looking to the future, rather than on the basis
of an antiquated formula, which peered into the past. The next major step
was the abolition of wealth tax on shares in 1992-93.
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21. Tax rates were reduced from a peak 97 per cent to 56 per cent in 1991 and
30% in 1997. Due to recent imposition of a surcharge and cess, it is almost
34% today.
Indian companies experienced the euphoria of market pricing and market
driven valuations for their company. Book building was introduced to
improve the transparency in pricing of the scripts and determine proper
market price for shares. The primary market saw a boom.
Simultaneously, the secondary market was given a lift up when trading
infrastructure in the stock exchanges was modernized by replacing the
open outcry system with on-line screen based electronic trading. This
improved the liquidity in the Indian capital market and led to better price
discovery.
The trading and settlement cycles were initially shortened from 14 days to
7 days. Subsequently, to enhance the efficiency of the secondary market,
rolling settlement was introduced on a T+5 basis. With effect from April 1,
2002, the settlement cycle for all listed securities was shortened to T+3 and
further to T+2 from April 1, 2003. Shortening of settlement cycles helped in
reducing risks associated with unsettled trades due to market fluctuations.
The establishment of National Securities Depository Ltd. (NSDL) in 1996
and Central Depository Services (India) Ltd. (CSDL) in 1999 has enabled
paperless trading in the exchanges. Trading in derivatives such as stock
index futures, stock index options and futures and options in individual
stocks was introduced to provide hedging options to the investors and to
improve 'price discovery'mechanism in the market. The Investor Protection
Fund (IPF) has also been set up by the stock exchanges. The exchanges
maintain an IPF to take care of investor claims.
Another significant reform has been a recent move towards corporatisation
and demutualisation of stock exchanges. The Bombay Stock Exchange was
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22. corporatised and demutualised in 2005.
Setting up of credit rating agencies, CRISIL, ICRA was significant but it has
not made a significant contribution to the retail market for corporate debt
instruments. The recent failure of a few large Initial Public Offers (IPOs)
issues and disappointing performance of some IPOs on listing, has
prompted regulators to suggest a mandatory rating for all new IPOs. The
recommendation has not yet been implemented.
The setting up of the National Stock Exchange of India Ltd. (NSE) as an
electronic trading platform set a benchmark of operating efficiency for
other stock exchanges.
Table 1.45 : Comparision of BSE and NSE
Bombay Stock Exchange Ltd National Stock Exchange of
Market Market
Year/ Turnover (Rs. Turnover (Rs.
2002-
5,72,198 3,14,073 5,37,133 6,17,989
2003-
12,01,207 5,03,053 11,20,976 10,99,535
2004-
16,98,428 5,18,715 15,85,585 11,40,071
2005-
30,22,191 8,16,074 28,13,201 15,69,556
2006-
35,45,041 9,56,185 33,67,350 19,45,285
* Rupees (Rs.) is the Indian currency and Rs. 1 is approximately equal to
$40 (average).
5
Source : Bombay Stock Exchange and National Stock Exchange.
Foreign Institutional Investors (FIIs) allowed since the mid-1990s, brought
160

23. with them better disclosure and corporate governance standards.
Foreign institutions were willing and able to pay a higher multiple for
earnings and they were also willing to pay for good corporate governance
standards. At present, around 1000 FIIs are registered with SEBI.
To attract retail investors into the equity market the mutual fund industry
was thrown open to the private sector and today one private fund, Reliance,
has overtaken UTI in terms of assets under management, with others close
behind.
Since 1980, after the second round of bank nationalization, the Reserve
Bank of India had not issued any private bank license. In a major move to
increase the efficiency of intermediation in the financial markets, the policy
was reversed and private sector banks were set up. Some of the more
enlightened all India financial institutions converted themselves into
commercial banks. ICICI was the first of the three lending institutions to do
so, and has now become the most valuable private sector bank in the
country.
Interestingly, ICICI was, ab initio, a listed company, with an independent
board accountable to public shareholders, which, perhaps, explains its
greater ability to transform. The next to transform from developmental
finance to commercial banking was IDBI. The last, IFCI, was closest to Delhi
and hence most suitable for misdirected lending under political pressure;
it nearly became a sick institution. Thus, even within financial institutions
there were different governance standards.
The advent of foreign institutional investors, the growth of the mutual
fund industry and the freedom to price issues gave a huge impetus to good
corporate governance. Institutional players were willing and able to pay
more than individual investors, so promoters found that their wealth was
multiplying in value. There was now no wealth tax, hence an incentive to
161

24. increase shareholder value. Price/earnings multiples were higher and, they
discovered, every rupee retained in the books of the company rather than
taken away through financial jugglery, enhanced their wealth far more.
Increasing shareholder value thus became a mantra and improved
corporate governance standards the means to achieve it.
1.6 Outcomes of Equity Market Reforms and Proactive Corporate
Governance Processes.
1.6.1. Impact on the Companies
Freedom to price issues and access to capital markets provided to first
generation entrepreneurs, set in motion a chain of events. Whereas earlier
only the already established houses had the wherewithal and the contacts
to obtain licenses to manufacture products and the connections with state
owned financial institutions to finance their projects, the field was now
open to anyone. Thus sprang first generation entrepreneurs, such as Infosys
Technologies, led by the well known N. R. Narayan Murthy, which ventured
into software services. This, a field where the biggest assets walked out the
door every evening, was not a venture traditional lenders, which lent
against asset backed securities, would have earlier considered fundable.
The equity market was also unsure of his venture and the IPO had to be
rescued by their investment bankers. Under Murthy's leadership, Infosys
raised the bar for good governance.
In one of its earlier analyst meetings, Murthy confessed that GE, its largest
customer accounting for a major share of turnover, had walked out on
them because Infosys refused to cut prices to get more business. More than
the event, it was the honesty and the chutzpah of the disclosure that
impressed analysts. The stock price never looked back and gave superlative
returns to early shareholders. Shareholders were willing to pay a higher
price for well-governed companies with good disclosures.
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25. On the flip side, corporate management realized that good governance
yielded commensurate returns.
Another first generation entrepreneur was Dhirubhai Ambani, who
founded Reliance Industries, now a FORTUNE 500 company. He was astute
enough to appreciate the value of the equity market and clever enough to
reward his shareholders so well that they subscribed to each new offering
of the group. He financed his ventures through frequent tapping of capital
markets, ensuring that he left enough on the table for his investors to want
more. The group is now split between his two sons, with both growing
sizeably.
n telecom, a new entrepreneur, Sunil Mittal set up Bharti Airtel, one of the
best performing stocks. Mittals forte was finding strategic and financial
investors with staying power, and building and maintaining relationships
with them.
Corporate governance has a cause-and-effect relationship with investor
expectations. As the market became institutionalised with the advent of
mutual funds, investor expectations of governance standards increased.
Simultaneously, institutional investors were willing and able to pay more
for companies with better governance.
Companies have now set up different committees for investor relations,
compensation, audit and others, with independent board members sitting
on each. Sometimes these committees are independent and effective,
sometimes not. Infosys Technologies is considered the benchmark of good
corporate governance; its CEO was recently fined by its audit committee
for neglect inadvertently failing to disclose certain transactions within the
24 hour time set for such disclosure. The committee asked him to pay the
fine as a donation to his favourite charity.
Annexure 1.2 compares the top 10 companies based on their market
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26. capitalization in 1992, a year after the economic reforms started; 2001,
around 10 years after the reforms were initiated; 2007, when the markets
were witnessing a boom and in 2008, after the sub prime problem in the
U.S and the subsequent volatile international capital market, as also a slow
down in the world economies.
The analysis is revealing. The top positions in 1992 were dominated by
private companies in steel, engineering, cement, FMCG, and capital goods.
In 2001, IT and telecommunications enjoyed the top slots and public sector
companies in oil and finance industries began making inroads into the
capital market.
A comparison between 2007 and 2008 reveals that well-governed
companies Bharti Airtel, TCS, Reliance Industries continue to find a place
among the top 10 companies despite the turbulence in the market while
several government controlled companies in the metals, mining &
commodities industries, enjoying a near monopoly position in their
industries, are now placed among the top 10.
1.6.2. Impact on the Equity Markets
One of the most significant ratios to measure the impact of reforms on the
equity market is stock market capitalization to GDP ratio.
Graph. : 1.1 :
1991 199319941995
1996
1997
1998
19992000
200120022003
2004
20052006
2007
6 Source : Currency & Finance, RBI, 2005-2006
164

27. Graph : 1.27 : Market Capitaliation as percent of GDP in select economies
(As at end-2005)
Hongkong UK
Singapore Aust rali a US
Japan K oreaThailand a Brazil Philipines Argentina
Indi Mexico
7
Source : Currency & Finance, RBI, 2005-200
During the recent boom in 2007, the market cap/GDP ratio in India jumped
up to 173 per cent, and it was feared that the market is overheated.
The turnover ratio (TOR) is measured by dividing the total value of shares
traded on a country's stock exchange by stock market capitalization. It is a
measure of trading activity or liquidity in the stock markets.
The value traded ratio (VTR), is the total value of domestic stocks traded on
domestic exchanges as a share of GDP. This ratio measures trading relative
to the size of the economy.
As is evident in the following table both TOR and VTR have significantly
improved since 1990-91, when the economic liberalization process began.
Between 1996-97 and 2000-01, the ratios reached high levels, largely
because of the rise in stock prices due to the boom in information
technology stocks.
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28. Table 1.5 : Liquidity in the Stock Market in India
(Per cent)
Value Traded
Year Turnover Ratio
1 2 3
1990-91 32.7 6.3
1991-92 20.3 11
1992-93 20 6.1
1993-94 21.1 9.8
1994-95 14.7 6.9
1995-96 20.5 9.9
1996-97 85.8 30.6
1997-98 98 38
1998-99 126.5 41.7
1999-00 167 78.1
2000-01 409.3 111.3
2001-02 134 36
2002-03 162.9 37.9
2003-04 133.4 57.9
2004-05 97.7 53.1
2005-06 78.9 66.9
2006-07 81.8 70.7
The National Stock Exchange was a leader in the trading of single stock
futures in 2006, according to the World Federation of Stock Exchanges. It
was at the fourth place in the trading of index futures.
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29. Table 1.68 : Top Five Equity Derivative Exchanges in the world - 2006
A. Single Stock Futures Contracts
No. of
Exchange Rank
National Stock Exchange, India 100,430,505 1
Jakarta Stock Exchange, Indonesia 69,663,332 2
Eurex 35,589,089 3
Euronext.liffe 29,515,726 4
BME Spanish Exchange 21,120,621 5
B. Stock Index Futures Contracts
No. of
Exchange Rank
Chicago Mercantile Exchange 470,180,198 1
Eurex 270,134,951 2
Euronext.liffe 72,135,006 3
National Stock Exchange, India 70,286,258 4
Korea Stock Exchange 46,562,881 5
Source : World Federation of Exchanges.
8
Source : Currency & Finance, RBI, 2005-200
As per the SEBI-NCAER Survey of Indian Investors, 2003, there has been
asubstantial reduction in transaction cost in the Indian securities market,
which declined from a level of more than 4.75 per cent in 1994 to 0.60
percent in 1999, close to the global best level of 0.45 per cent. Further, the
Indian equity market had the third lowest transaction cost after the US
and Hong Kong.
Despite the positive impact of the reforms, households continue to have a
limited investment in the equity markets, including the mutual funds
market. (See table 1.7).
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30. Table 1.79 : Share of Various Instruments in Gross Financial Savings of
the Household Sector in India
(Per cent)
Bank and non - Insurance, PF, Units of Claims on Shares and
Period Currency
1970-71
13.9 48.6 31.3 0.5 4.2 1.5
1980-81
11.9 45 25.9 2.2 11.1 3.9
1990-91
10.8 39.6 25.5 6.6 8.1 9.4
1995-96
9.7 43.4 30.5 0.9 10.8 4.7
2000-01
8.9 40.9 29 -0.8 18.8 3.2
@: Includes investment in shares and debentures of credit/non-credit
Note : Gross financial savings data for the year 2004 are on new base, i.e.,-05
9
Source :Handbook of Statistics on the Indian Economy, 2005-06, RBI.
An important question is how far are do the reforms in the capital market
benefit the Indian retail investors. In fact, the India growth story has
attracted foreign institutional investors (FIIs) in a big way, with global majors
like CLSA, HSBC, Blackstone, Fidelity, Goldman Sachs, Citigroup, Morgan
Stanley, UBS, T Rowe Price International, among others, entering the capital
market. Several sovereign pension funds like, the Netherlands' ABP
(Algemeen Burgerlijk Pensioenfonds), Norway's The Government Pension
Fund - Global (Statens pensjonsfond - Utland) and Denmark's
Lonmodtagernes Dyrtidsfond (LD Pensions) have invested over $1.2 billion
(nearly
Rs. 5,000 crore) in India.
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31. This has increased the buoyancy as also the volatility in the stock markets.
With a net cumulative investments of around $65 billion, FIIs account for
around 25 per cent of the floating stocks in the Indian stock markets.
Till recently, Indian pension funds were disallowed investment in Indian
equities. After three years of delays and discussions on Project OASIS (Old
Age Social and Income Security) Report tabled by SA Dave in 2001, the
Pension Fund Regulatory & Development Authority Ordinance was passed
in 2004. It allows investment of pension funds up to 5 per cent in to equities
and another 10 per cent in to equity linked mutual funds. Around 95 per
cent of government backed pension funds are locked in low-yielding
government paper.
This denies Indian pension funds the right to reap the benefits of economic
reforms and the great 'India shining' story.
India needs a market driven corporate governance culture with greater
participation from Indian retail investors, either directly or through mutual
funds; entry of government pension funds into the equity market in a really
competitive mode, with checks, balances and transparency in line with the
Norwegian sovereign fund's high standards of corporate governance and
a close, alert regulatory oversight to ensure compliance with the well-
drafted codes and clauses.
The Indian equity market presents an opportunity for a real transformation
to the Indian landscape. If India misses this opportunity, the Indian growth
story would benefit foreign pension funds and high net worth investors/
promoter-families more than the Indian on the street. This is not much
different from the British Empire days when India's wealth enriched the
coffers of the British, and the wealthy Indian business community.
1.10 Summing Up
a) Historically Indian companies had no incentive to show higher profits
169

32. on their books and enhance shareholder value. This was on account
of a very high tax structure - both personal/corporate and also wealth
tax.
b) The private sector was also denied access to the equity market at fair
market valuations due to strict control of the pricing of public issues
by the erstwhile Comptroller of Capital Issues. The combination of high
taxes and low valuations left no incentive for good corporate
governance.
c) The early beginnings of corporate governance was an outcome of the
repealing of the Capital Issues (Control) Act, 1947, in 1992 paving the
way for market forces in the determination of pricing of issues and
allocation of resources for competing uses. Tax rates were reduced
from a peak 97 per cent to 56 per cent in 1991 and 30% in 1997. Due to
recent imposition of a surcharge and cess, it is almost 34% today.
d) Indian companies experienced the euphoria of market pricing and
market driven valuations for their company. Corporate management
realized that good governance yielded commensurate returns.
e) Though India has not experienced large scale corporate scandals like
those experienced by the U.S., this is more a result of a convergence of
the interest of management and owners (both constituted by the
dominant promoter-family/dominant government holding), rather
than because of higher standards of corporate governance.
f) The predominant issue in India is the conflict between "dominant"
shareholder-promoter groups and minority shareholders. There are
around 250 big and small listed companies with promoter holding of
over 75 per cent each. The prominent among them are Wipro, Tata
Consultancy Services, Jet Airways, DLF, Puravankara Projects, Akruti
City, Omaxe, Plethico Pharmaceuticals, Sobha Developers, Mundra
170

33. Port, BGR Energy, Blue Dart, Parsvnath Developers, and Bosch Chassis.
The promoters, in most cases, currently hold over an 80 per cent stake
in these companies.
g) Unlike in Japan/Germany, where banks play a critical role, as creditors,
in the corporate governance of companies, in India, though banks/ FIs
had large debt exposures to the Indian corporate sector, (and with a
conversion clause in the loan agreement the debt was often converted
into an equity holding) several studies have shown that they did not
exercise close monitoring of the corporate governance standards in
these companies.
h) It is observed that in the Indian context, the external market exercises
a limited force on corporate governance (since the floating stock in
the secondary market is limited). Nor is the internal force of a strong
Board (since management and Board members are, very often, from
the same dominant promoter group) always effective in protecting
the principles of sound corporate governance.
Despite globalization, and an increase in foreign institutional investment
in Indian companies, institutional activism is also weak and yet to
emerge as a strong counter force. Institutional investors, both domestic
and foreign, are more prone to vote with their feet, by exiting the stock,
than to influence a change in management behavior.
i) India needs a market driven corporate governance culture with greater
participation from Indian retail investors, either directly or through
mutual funds; entry of government pension funds into the equity
market in a really competitive mode, with checks, balances and
transparency in line with the Norwegian sovereign fund's high
standards of corporate governance and a close, alert regulatory
oversight to ensure compliance with the well-drafted codes and
171

34. clauses.
Corporate governance goes beyond crises, committees and
compliances.
j) The corporate board reflects the spirit of corporate governance of a
company. To understand the corporate governance of a country it is
imperative to understand the framework of its corporate boards.
Table 1.1COMPARISON ON OF TOP MARKET CAPITALIZATION
COMPANIES SINCE ECONOMIC LIBERALIZATION
Rank Company Type of Industry Ow nership
1 TISCO LTD. Steel Private
2 ITC LTD. Tobacco Private
3 RELIANCE INDUSTRIES LTD. Diversified Private
4 HIND LEVER LTD. FMCG Multinational
as on
5 TELCO Automobiles Private
6 ACC LTD Cement Private
7 ICICI LTD Finance Private
8 LARSEN & TOUBRO LTD. Capital Goods Private
9 CENTURY TEXTILES & INDS. Textiles Private
10 GRASIM INDUSTRIES LTD. Diversified Private
1 WIPRO LTD. IT Private
2 HIND UNILEVER LTD. FMCG Multinational
3 RELIANCE INDUSTRIES LTD. Diversified Private
4 INFOSYS TECHNOLOGIES LTD IT Private
as on
5 ONGC Oil & Petroleum Public
6 ITC LTD. Diversified Private
7 HCL TECHNOLOGIES IT Private
8 INDIAN OIL CORPORATION LTD Oil & Petroleum Public
9 STATE BANK OF INDIA Finance Public
10 MTNL Telecommication Public
1 RELIANCE INDUSTRIES LTD. Diversified Private
2 ONGC Oil & Petroleum Public
3 BHARTI AIRTEL LTD Telecom Private
4 NTPC LTD Power Public
as on
5 RELIANCE COMMUNICATIONS Communications Private
6 INFOSYS TECHNOLOGIES LTD IT Private
7 TATA CONSULTANCY SERVICES IT Private
8 DLF LIMITED Housing related Private
9 ICICI BANK LTD Finance Private
10 BHEL Capital Goods Public
1 RELIANCE INDUSTRIES LTD. Diversified Private
2 ONGC Oil &Petroleum Public
3 NMDC Minerals & Mining Public
4 NTPC Power Public
as on
5 Bharti Airtel Communications Private
6 Mineral & Metal Minerals & Mining Public
7 SBI Finance Public
8 DLF Housing related Private
9 RELIANCE COMMUNICATIONS. Commun ications Private
10 TATA CONSULTANCY SERVICES IT Private
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35. Author’s Profile
Prof. Dr. Uday Salunke Director - Welingkar Institute of Management is a mechanical engineer with a management
degree in 'Operations', and a Doctorate in 'Turnaround Strategies'. He has 12 years of experience in the corporate world
including Mahindra & Mahindra, ISPL and other companies before joining Welingkar in 1995 as faculty for Production
Management. Subsequently his inherent passion, commitment and dedication toward the institute led to his appointment as
Director in 2000. Dr. Salunkhe has been invited as visiting fellow at the Harvard Business School, USA and European
University, Germany. He has also delivered seminars at the Asian Institute of Management, Manila and has been
awarded "The Young Achievers Award-2003" in the field of Academics by the Indo American Society recently.
173