This article has been written by Giri Aravind and Adarsh Vijayakumaran, Third year students at National University of Advanced Legal Studies
600 years ago, Machiavelli in his writing The Prince, portrayed a brutal picture of the State where the body politic acts as a centralizing force, sweeping aside all moral considerations and focusing on its strength, vitality, and courage as a ruler. Six centuries later, the concept of the State as a governor of institutions and enterprises both profit-seeking and otherwise have not changed as long as its ways, objectives, and motives are concerned. This article endeavours to bring out the concept of institutional nepotism in the issuance of IPOs of State-owned enterprises. It will further address how such a mechanism affects the investors and whether such interaction is healthy for the market as a whole.
The term Initial Public Offering (‘IPOs’) refers to the initial sale of shares to the public by a company that has so far been a private one. In this context, IPOs represent the transition of a closeted private enterprise to a public one where bolted sheets of the companies become available to the public for both study and scrutiny. OECD data of selected 34 countries shows that the State-owned enterprises of the countries are valued at around 2 trillion USD. The Indian telecom infrastructure provider RailTel, for example, is valued at around Rs 3000 billion and is now lining up to raise Rs 7 billion through an initial share-sale. These number clearly shows that the primary motive for a State to issue IPOs has always been to raise capital to meet its rising demands.
The whole process of launching the IPO of a private company starts with amending the Memorandum and Articles of Association of that company, followed by submission of a registration statement to the securities regulator, preparation of prospectus, deciding on price band, and public issuance. These procedures are extremely extensive and usually take 6 months to 2 years. However, one aspect that remains common at every stage of an IPO is its increased demand to comply with all the laws of the State and State-supported institutions. Interestingly, even with all its strictness, the law generally provides a leeway for companies where at least 51% of the shareholding is owned by the Government. This phenomenon where State regulators provide various considerations or exemptions to other State ownerships is called institutional nepotism.[i] Unlike customary nepotism, institutional nepotism has larger objectives with a wide number of stakeholders all being the beneficiaries of the State.
Institutional nepotism is a very common phenomenon in the issuance of IPOs of a Government company. These companies, both State created and State acquired, undergo massive internal and external transformations during their IPO processes. These transformations become more obvious in cases of State-created companies where popular votes are sought to transform their underlying legislations. It is during such instances that the concept of institutional nepotism becomes relevant.
Even though the concept of institutional nepotism has dipped itself deep into the prevailing market practices, to call out a certain situation to be an instance of institutional nepotism would be a herculean task, irrespective of the State’s economy being a socialist, capitalist, or a mixed one. However, for the purpose of this article, we shall introduce two scenarios, one, where the accompanying legislation itself has allowed institutional nepotism, and two, where Government institutions have brought changes in the existing framework to ease the transaction where the protagonist is a Government enterprise.
The instances where the legislation itself provides leeways for Government enterprises are easy to spot. They are usually in the form of waivers, exemptions, absent listing fees, and other mechanisms where a ‘discretion factor’ is left with the regulator to allow a Government enterprise to issue IPOs without fulfilling certain requirements. For example, in the United Kingdom, while listing securities of a Government-owned company, the State, and other regional and local authorities are not required to comply with chapter 5 of the Listing Rules, instead, these companies are required to offer a different instrument with adaptations according to the issuer.
On the other hand, Government institutions sometimes work very closely to bring structural changes in the existing framework so that a particular IPO of a Government ownership could be launched with ease. An example of this type of collaboration for institutional nepotism can be observed in the launch of Life Insurance Corporation’s (LIC) IPO in India, where the market regulator—Securities Exchange Board of India, has very recently proposed a consultation paper to reduce the size of IPOs so that the Government company—LIC—could introduce the offering with ease considering its monumental market size. Currently, all listed companies are required to comply with the minimum public shareholding requirement of 25% within three years of their listing[ii] and those launching an IPO are required to sell at least 10% of the shares initially outstanding in the IPO .[iii] SEBI’s proposal, if implemented, will allow companies having a post-issue capital of ₹10,000 crore or more to initially sell only 5% of the company to the public as against the existing rule.
two sides of the coin
The impact of institutional nepotism on the market can be varied. On one hand, it can allow large Government corporations to be easily listed on the stock exchange and raise capital without any hassle. In contrast, it can also lead to stark inequalities in the application of regulations between a Government-owned company and a private entity in the same industry.
Government companies may pursue the issuing of IPOs with different objectives as compared to private firms. While raising funds may be the major influencing factor in the case of the latter, the decision to list a Government firm is influenced by both economic as well as political reasons. For example, Governments often allocate a significant portion to domestic investors. This is usually done by discounting stocks. While it is often argued that discounting stocks might lead to the Government enterprises being offered at a rate lesser than its market value, this is done in order to attract larger domestic and retain investors, as opposed to foreign and institutional investors.[iv]
During such instances, bestowing State enterprises with regulatory exemptions or waivers can have a positive impact. IPOs and public listing are usually more expensive to execute compared to other methods of privatization like auction or trade-off. Moreover, IPO transactions are quite complex and often require immense specialised expertise as the chance of loss of revenue owing to discounting of shares and offering incentives are much higher. The enterprises are also required to comply with a plethora of listing requirements and national corporate governance codes. Here, waivers or leeways by the concerned regulatory authority can make the process of privatization of these State-owned enterprises smooth and hassle-free.[v]
At the same time, regulatory exemptions only for State-owned companies can lead to inequalities in the market. In a mixed economy, both private as well as Government-owned firms play an equal part in the overall development of the country. Granting concessions to only State-owned enterprises can lead to gross discrimination in the market. Governments may even create an uneven playing field in markets where a Government company competes with private firms, as they have a vested interest in ensuring that State-owned firms succeed. Thus, despite its role as a market regulator, the securities regulatory institutions may promote anti-competitive behaviour by granting State-owned companies various benefits that are not offered to private firms.[vi]
In fact, State-owned enterprises already enjoy a plethora of benefits over private entities. The former often enjoy Government provided credit guarantees or have access to favourable credit rates that reduce their cost of borrowing. For example, in the United States, the Postal Service is allowed to borrow directly from the Federal Financing Bank which guarantees public bonds at interest charges which are lower than the market rates for private companies of comparable risk.
Additionally, the control of a State-owned entity cannot be easily transferred as opposed to private companies, whose stocks are easily tradeable. Thus, when a Government company fails to perform well, the investors, i.e., the taxpayers do not usually have an option to pull out their funds. They can, of course, attempt to exercise their voting rights and can influence the related Governmental policies, but this is not the most efficient method to bring about a sudden change. This inability of the stakeholders to have a quick say in the working of a Government firm can lead to the management not having enough incentive to efficiently run the company. Thus, locking its capital allows the company to run even with losses for long periods without any fear of bankruptcy.[vii]
Institutional nepotism, therefore, has its own merits and demerits. On one hand, it can render the complex and tedious process of listing the State-owned companies in the stock exchange easier, leading to faster generation of revenue. On the other hand, excessive exemptions and waivers could result in the enterprise slowly acquiring a dominant position and creating a monopoly in the market. Thus, it must be ensured that any framework introduced for the benefit of the Government companies in the IPO stage as well as thereafter must be competitively neutral and the conditions in which these companies operate must try to closely match those of their private counterparts. In other words, the various antitrust authorities must strive to make sure that any regulatory leeway provided to State-owned companies must be transparent and should not result in any unfair advantage over private enterprises.
[i] John A. C. Hetherington, Mutual and Cooperative Enterprises: An Analysis of Customer-owned Firms in the United States39(1991).
[ii] Rule 19A. Securities Contracts (Regulation) Rules, 1957.
[iii] Rule 19(2)(b), Securities Contracts (Regulation) Rules, 1957.
[v] See generally Kunmin Kim and N. Panchanatham, Reform and Privatization of State-Owned Enterprises in India, ADBI Working Paper Series (2019), https://www.adb.org/sites/default/files/publication/546876/adbi-wp1057.pdf.
[vi] See David E.M. Sappington & J. Gregory Sidak, Competition Law for State-Owned Enterprises, Antitrust Law Journal No. 2 (2003).
[vii] See Geddes, Case Studies of Anticompetitive SOE Behavior, in Competing with the Government, Anticompetitive Behaviour and Public Enterprises, Hoover Institution Press, 2004.