The most striking fact about India’s legal system is the difference between investor protection provided by the law as opposed to protection in practice. Table 2.1 compares India’s scores relative to different legal-origin country groups examined in the law and finance literature (by LLSV and others), and other emerging markets along several dimensions of law and institutions. As discussed above, with the English common-law system, India has strong protection of investors on paper. For example, the scores on both creditor rights (with a score of 4/4 in LLSV (1998), based on the Company’s Act of 1956, to 2/4 in DMS (2005), based on the Sick Industrial Companies Act of 1985) and shareholder rights (5/6) are the highest of any country in the world.

Corruption is a major systemic-problem in many developing countries and is of particular importance for India. Studies by the World Bank (World Development Report 2005) have found that corruption was the number one constraint for firms in South Asia and that the two most corrupt public institutions identified by the respondents in India (as well as in most countries in South Asia) were the police and the judiciary. Based on Transparency International’s Corruption Perception Index, India has a score of 2.9 out of 10 in 2005 (a higher score means less corruption), which ranked 88 out of 140 countries (with the range being 1.5 to 9.7), and the ranking relative to other countries has not improved much over the past ten years.

Next, we have two measures for the quality of accounting systems. The disclosure requirements index (from 0 to 1, higher score means more disclosure; LLS 2006) measures the extent to which listed firms have to disclose their ownership structure, business operations and corporate governance mechanisms to legal authorities and the public. India’s score of 0.92 is higher than the averages of all LLSV subgroups of countries, including the English origin countries, suggesting that Indian firms must disclose a large amount of information. However, this does not imply the quality of disclosure is also good. In terms of the degree of earnings management (higher score means more earnings management; Leuz, Nanda, and Wysocki 2003), India’s score is much higher than the average of English origin countries, and is only lower than the German origin countries, suggesting that investors have a difficult time in evaluating Indian companies based on publicly available reports. It seems that while Indian companies produce copious amounts of data, form triumphs over substance in disclosure and with an accounting system that allows considerable flexibility, there is enough room for companies to hide or disguise the truth.

The efficiency and effectiveness of the legal system is of primary importance for contract enforcement, and we have two measures. First, according to the legal formalism (DLLS 2003) index, India has a higher formalism index than the average of English origin countries, and is only lower than that of the French origin countries. The legality index, a composite measure of the effectiveness of a country’s legal institutions, is based on the weighted average of five categories of the quality of legal institutions and government in the country (Berkowitz, Pistor, and Richard 2003). Consistent with other measures, India’s score is lower than the averages of all the subgroups of LLSV countries, suggesting that India’s legal institutions are less effective than those of many countries, and that it will be more difficult; for India to adopt and enforce new legal rules and regulations than other countries.

Finally, as for the business environment in India, a recent World Bank survey
found that, among the top ten obstacles to Indian businesses, the three which the firms
surveyed considered to be a “major” or “very severe” obstacle and exceeding the world average are corruption (the most important problem), availability of electricity, and labor regulations. Threat of nationalization or direct government intervention in business is no longer a major issue in India. With rampant tax evasion, the shadow economy in India is significant. It is estimated to be about 23% of GDP. Creditor and investor rights were largely unprotected in practice, with banks having little bargaining power against willful defaulters. Large corporate houses often got away with default, or got poor projects financed through the state-owned banking sector, often by using connections with influential politicians and bureaucrats.

Since the beginning of liberalization in 1991, two major improvements have taken place in the area of creditor rights protection – the establishment of the quasi-legal Debt Recovery Tribunals that have reduced delinquency and consequently lending rates (Visaria (2005)); and the passing of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act in 2002 and the subsequent Enforcement of Security Interest and Recovery of Debts Laws (Amendment) Act in 2004. These laws have paved the way for the establishment of Asset Reconstruction Companies and allow banks and financial institutions to act decisively against defaulting borrowers. In recent years,-recovery has shown significant improvement, presumably because, at least in part, of a well-performing economy (Table 2.1).

2.1. Comparison of Legal Systems: India, Country Groups and Major Emerging Economics*

Creditor

Rights

Anti-director

Rights

Corruption Perception Index

Legal Formalism

Index

Legality

Index

Disclosure

Requirement

Earnings

Managem Score

India

2

5

3.3

3.51

11.35

0.92

19.1

English-origin Ave.

2.28

4.19

5.33

3.02

15.56

0.78

11.69

French-origin Ave.

1.31

2.91

4.39

4.38

13.11

0.45

19.27

German-origin Ave.

2.33

3.04

5.58

3.57

15.53

0.60

23.60

Nordic-origin Ave.

1.75

3.80

9.34

3.32

16.42

0.56

10.15

LLSV Sample Ave.

1.828

3.3729

5.24

3.5830

14.98

0.6031

16.00

China (G)

2

1

3.3

3.40

N/a

N/a

N/a

Pakistan (E)

1

4

2.2

3.74

8.27

0.58

17.8

S. Africa (E)

3

5

4.6

3.68

11.95

0.83

5.6

Argentina (F)

1

2

2.9

5.49

10.31

0.50

N/a

Brazil (F)

1

5

3.3

3.83

11.43

0.25

N/a

Mexico (F)

0

3

3.3

4.82

10.79

0.58

N/a

Malaysia (E)

3

5

5

3.21

13.82

0.92

14.8

Sri Lanka (E)

2

4

3.1

3.89

9.68

0.75

N/a

Thailand(E)

2

4

3.6

4.25

10.70

0.92

18.3

Egypt (F)

2

3

3.3

3.60

10.14

0.50

N/a

Indonesia(F)

2

4

2.4

3.88

8.37

0.50

18.3

Peru(F)

0

3.5

3.3

5.42

9.13

0.33

N/a

Philippines (F)

1

4

2.5

5.00

7.91

0.83

8.8

Turkey (F)

2

3

3.8

3.49

9.88

0.50

N/a

Korea (South )(G)

3

4.5

5.1

3.33

12.24

0.75

26.8

Taiwan (G)

2

3

5.9

3.04

14.26

0.75

22.5

Average of EM

1.69

3.63

3.60

4.00

10.59

0.63

16.61

Source of EM

* Including all emerging economies from Table 1 for which information was available. Notation (E), (F), or (G) against a country indicates that the said country belongs to English, Fresh or German legal origin groups.

28 : DMS average 30 : DLLS (2003) average

29 : DLLS (2007) average 31 : LSS (2006) average

To summarize, despite strong protection provided by the law, legal protection is considerably weakened in practice due to an inefficient judicial system, characterized by overburdened courts, slow judicial process, and widespread corruption within the legal system and government. While the need for judicial and legal reforms has long been recognized, little legislative action has actually taken place so far (Debroy (2000)). Currently, the government is trying to emulate the success of China by following the Special Economic Zone approach rather than overhauling the entire legal system.

Financial/Business Laws and Regulations in India

Red tape and regulations still rank among the leading deterrents for business and foreign investment in India leading to its latest ranking of 116 out of 155 in the World Bank’s Ease of Doing Business indicator in 2006 (World Bank, 2006). India features consistently in the second half of the sample for all aspects of business regulation (and is out of the top 100 for most aspects) except for investor protection. To start a business in India entrepreneurs have close to twice the number of procedures to follow as in OECD countries, about three and a half times the time delay and close to nine times the cost (as a proportion of per capita income). Delays and costs of dealing with licenses in India is roughly in corresponding proportions with their respective OECD values. Very recently (second half of August 2007), the Government of India has decided to improve this situation and has announced a drastic reduction in the number of approvals and permits necessary to start new business. Whether and when this translates to actual practice is yet to be seen.

It is almost twice as hard to hire people in India as in OECD countries and almost three times as hard and costly to fire them. With have considerable variation in their labor laws across states, Besley and Burgess (2004) show that during the three and half decades before liberalization began in 1991, Indian states that followed more pro-worker policies experienced lower output, investment, employment and productivity in the registered or “formal” sector and higher urban poverty with an increase in informal sector output.

In the area of credit availability, India lags behind not because of creditors’ rights (which is close to OECD standards) but because of the paucity of credit quality information through the use of public registry or coverage of private bureaus. However, India’s excellent investor protection provisions in the law should be viewed together with her performance in contract enforcement where the number of procedures and time delays are about double that in OECD countries and the costs of contract enforcement over four times that in OECD countries.

As for securities markets regulation, using the framework of La Porta et al (2006) that focuses on disclosure and liability requirements as well as the quality of public enforcement of the regulations controlling securities markets, India scores 0.92 in the index of disclosure requirements third highest after the United States and Singapore. As for liability standard, India’s score is the fifth highest, 0.66 while the sample mean is 0.47. In terms of the quality of public enforcement, i.e. the nature and powers of the supervisory authority, the Securities and Exchanges Board of India (SEBI), India scores 0.67, higher than the overall sample mean as well as the English-origin average of 0.52 and 0.62 respectively and ranks 14th in the sample.

In comparing the regulatory powers and performance of SEBI with those of the SEC (Securities and Exchanges, Commission) in the USA, Bose (2005) concludes that while the scope of Indian securities laws, are quite pervasive, there are significant problems in enforcing compliance, particularly in the areas like price manipulation and insider trading. Between 1999 and 2004, Bose finds that SEBI took action in 481 cases as opposed to 2,789 cases for the SEC even though the latter regulates a significantly more mature market. As a ratio of actions taken to the number of companies under their respective jurisdictions, SEBI’s figure comes out to be an unimpressive 0.09 while that of the SEC is 0.52. Also the ratio for action taken to investigations made is quite low for SEBI (e.g. 1 out of 24 cases of issue related manipulation in 1996-97, 7 out of 27 in the 5 year period 1999-2004). As for appeals before higher authorities – the Securities Appellate Tribunal (SAT) or the Finance Ministry – in 30 to 50% of cases, the decision goes against SEBI. Though SEBI has had some success prosecuting intermediaries, it has failed to convince the SAT in its proceedings against corporate insiders and major market players. Thus the quality of public enforcement of securities laws appears to be a problem in India.

The institution of Debt Recovery Tribunals (DRTs) in the early 90’s and the
passing of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act in 2002 were aimed at remedying the slowness of the judicial process. The SARFAESI Act paves the way for the establishment of Asset Reconstruction Companies (ARCs) that can take the Non-Performing Assets (NPAs) off the balance sheets of banks and recover them. Operations of these ARCs would be restricted to asset reconstruction and securitizatipn only. It also allows banks and financial institutions to directly seize assets of a defaulting borrower who defaults fails to respond within 60 days of a notice. Borrowers can appeal to DRTs only after the assets are seized and the Act allows the sale of seized assets. The SARFAESI Act itself, however, does not provide a final solution to the recovery problems. With the borrower’s right to approach the DRT, the DRAT (Debt Recovery Appellate Tribunal) and, in some cases, even a High Court, a case can easily be dragged for three to four years during which time the sale of the seized asset cannot take place. It is perhaps too soon to evaluate its effects on reducing defaults but, public sector banks have had some success recovering their loans by seizing and selling assets since the Act came into existence. The recovery rates of bad debts have registered a sharp rise in 2005-06, but it is difficult to separate the contribution of the booming economy to this from that of the improvement in corporate governance.

Another positive development in the area of disclosure has been the adoption of Accounting Standards (AS) 18 by the Institute of Chartered Accountants in India (ICAI) in 2001 which, among other things, makes reporting of “related party transactions” by Indian companies mandatory. Related parties include holding and subsidiary companies, key management personnel and their direct relatives, “parties with control exist” which includes joint ventures and fellow subsidiaries; and other parties like promoters and employee trusts. Transactions include purchase/sale of goods and assets, borrowing, lending and leasing, hiring and agency arrangements, guarantee agreements, transfer of research and development and management contracts. This step has gone a long way in bringing transparency to the dealings of Indian companies, particularly the group-affiliates.

The area of the Ease of Doing Business index where India fares worst is undoubtedly that of closing a business. India has the dubious distinction of being among the countries where it takes the longest time to go through bankruptcy in the world (10 years on an average). Consequently recovery rates are very low too – below 13% as opposed to about 74% in OECD countries. Kang and Naya’r (2004) point out that there is no single comprehensive and integrated policy on corporate bankruptcy in India in the lines of Chapter 11 or Chapter 7 US bankruptcy code. Overlapping jurisdictions of the High Courts, the Company Law Board, the Board for Industrial and Financial Reconstruction (BIFR) and the Debt Recovery Tribunals (DRTs) contribute to the costs and delays of bankruptcy. The Companies (Second Amendment) Act, 2002 seeks to address these problems by establishing a National Company Law Tribunal and stipulating a time-bound rehabilitation or liquidation process to within less than two years as well as bringing about other positive changes in the bankruptcy code.

Stock Exchanges in India

India currently has two major stock exchanges: the National Stock Exchange (NSE) established in 1994 and the Bombay Stock Exchange (BSE), the oldest stock exchange in Asia, established in 1875. Up to 1992, BSE was a monopoly, marked with inefficiencies, high costs of intermediation, and manipulative, practices, so that external market users often found themselves disadvantaged. The economics reforms created four new institutions: the Securities and Exchanges: Board of India (SEBI), the National Stock Exchange (NSE), the National Securities Clearing, Corporation (NSCC), and the National Securities Depository (NSDL). The National Stock Exchange (NSE), a limited liability company owned by public sector financial institutions, now accounts for about two-thirds of the stock exchange trading in India, and virtually all of its derivatives trading.

The National Securities Clearing Corporation (NSCC) is the legal counter-party to net obligations of each brokerage firm, and thereby eliminates counter-party risk and possibility of payments crises. It follows a rigorous ‘risk containment’ framework involving collateral and intra-day monitoring. The NSCC, duly assisted by the National Securities Depository (NSDL), has an excellent record of reliable settlement schedules since its inception in the mid-nineties.

The Securities and Exchanges Board of India (SEBI) has introduced a rigorous regulatory regime to ensure fairness, transparency and good practice. For example, for greater transparency, SEBI has mandated mandatory disclosure for all transactions where total quantity of shares is more than 0.5% of the equity of the company. Brokers disclose to the stock exchange, immediately after trade execution, the name of the client in addition to trade details; and the Stock exchange disseminates the information to the general public on the same day.

The new environment of transparency, fairness and efficient regulation led BSE, in 1996, to also become a transparent electronic limit order book market with an efficient trading system similar to the NSE. Equity and equity derivatives trading in India has sky­rocketed to record levels over the course of the last ten years.

In 2005, about 5000 companies were listed and traded on NSE and/or BSE. While the dollar value of trading on the Indian stock exchanges is much lower than the dollar value of trading in Europe or in the US, it is important to note that the number of equity trades on BSE/NSE is ten times greater than that of Euronext or London, and of the same order of magnitude as that of NASDAQ/NYSE. Similarly, the number of derivatives trades on NSE is several times greater than that of Euronext/ London, and of an order of magnitude comparable to US derivatives exchanges. The number of trades is an important indicator of the extent of investor interest and investor participation in equities and equity trading, and emphasizes the crucial importance of corporate governance practices in India.

Enforcing Corporate Governance Laws

Enforcement of corporate laws remains’ the soft underbelly of the legal and corporate governance system in India. The World Bank’s Reports on the Observance of Standards and Codes (ROSC) in its 2004 report on India (World Bank (2004)) found that while India observed or largely observed most of the principles, it could do better in areas like the contribution of nominee directors from financial institutions to monitoring and supervising management; the enforcement of certain laws and regulations like those pertaining to stock listing in major exchanges and insider trading as well as in dealing with violations of the Companies Act – the backbone of the corporate governance system in India. Some of the problems arise because of unsettled questions about jurisdiction issues and powers of the SEBI.

Indian Courts-an assessment

Djankov et al (2003) (DLLS) in. their analysis of “formalism” in the judicial process around the world, gave India a score of 3.34 on its formalism index, higher than the English-origin average of 2.76 but slightly lower than the average for all countries, 3.53. Among the 42 English-origin countries in their sample, India has the 11th highest level of formalism. India has the 16th longest process of evicting a tenant (212 days) among English common law origin countries (average 199 days). For collection on a bounced check, however, India has the 16th shortest duration (106 days) among English common law origin countries (average 176 days). In both cases India’s total duration of the process is significantly shorter than the overall mean duration of all the 109 countries considered (254 for eviction of tenant and 234 for collecting on bounced check). Thus, in spite of its formalism, Indian courts do not seem to perform that poorly (relatively speaking) on these two types of eases considered.

The DLLS assurance notwithstanding, case arrears and decade-long legal battles are commonplace in India. In spite of having around 10,000 courts (not counting tribunals and special courts), India has a serious, shortfall of judicial service. While the USA has 107 judges per million citizens, Canada over 75, Britain over 50 and Australia over 41, for India the figure is slightly over 10, (Debroy (1999)). In April 2003, for instance, the Supreme Court of India had close to 25,000 cases pending before it (Parekh 2001). Hazra and Micevska (2004) report that there are about 20 million cases pending in lower courts and another 3.2 million cases in high courts. A termination dispute contested all the way can take up to 20 years for disposal. Writ petitions in high courts can take between 8 and 20 years for disposal. About 63% of pending civil cases are over a year old and 31% are over 3 years old. Automatic appeals, extensive litigation by the government, underdeveloped alternative mechanisms of dispute resolution like arbitration, the shortfall of judges all contribute to this unenviable state of affairs in Indian courts. Since the same courts try both civil and criminal matters and the latter gets priority, economic disputes suffer even greater delays.

The Small and Medium Enterprises (SME) sector in India

Allen et al (2006) conduct surveys to study the extent to which the formal legal environment directly supports and regulates businesses, particularly small and medium enterprises which form an increasingly important part of the Indian industry. This seems to indicate that the small firms sector operate in a system virtually governed through informal mechanisms based on trust, reciprocity and reputation with little recourse to the legal system and deals with widespread corruption.

Over 80% of the firms surveyed needed a license to start a business, and for about half of them obtaining it was a difficult process. Government officials were most often the problem solved usually through payment of bribes or friends of government officials to negotiate. Clearly, networks and connections are of crucial importance in negotiating the government bureaucracy.

As for conducting day-to-day business, legal concerns are far less important to

them than the unwritten codes of the informal networks in which firms operate. In cases of default and breach of contract, the primary concern is loss of reputation, followed closely by loss of property, with the fear of legal consequences being-the least important concern.

About half of the firms surveyed did not have, a regular legal adviser and less than half of those that did had lawyers in that capacity. For mediation in a business dispute or to enforce a contract, the first choice was “mutual friends or business partners”. Only 20% of the respondents mentioned going to courts as the first option indicating that the legal system, while not as effective as the informal mechanisms, is not altogether absent.

The informal system, however, is not perfect in resolving disputes and has its costs. About half of the respondents experienced a breach of contract or, non-payment with a supplier or major customer in the past three years. Over a third of them renegotiated while over 40% did nothing but continued the business relationships with the offending parties.

In general, the business environment of the SME sector is marked by strong informal mechanisms like family ties, reputation and trust. Legal remedies though present, are far less important than the rules of the informal networks.

References

Allen, F., R. Chakrabarti, S. De, J. Qian and M. Qian, 2006, “Financing Firms in India”, Working paper, The Wharton School.

Bose, Suchismita and Dipankar Coondoo, 2004, ‘The Impact of FII Regulations in India’, Money and Finance, July-December.

Bose, Suchismita, 2005. “Securities Markets Regulation: Lessons from US and Indian Experience”, Money and Finance, Jan-June, 83-124.

Besley, Timothy and Robin Burgess, 2004, “Can Labor Regulation Hinder Economic Performance? Evidence from India” Quarterly Journal of Economics.

Debroy, Bibek, 1999, “Some Issues in Law Reform in India”, in Jean-Jacques Dethier ed. Governance, decentralization, and reform in China, India, and Russia,. Boston; Kluwer Academic Publishers.

Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, 2002. “The Regulation of Entry,” Quarterly Journal of Economics, “Courts,” Quarterly Journal of Economics, 118 (2), 453-517.

Hazra, Arnab K. and Maja Micevska, 2004, “The Problem of Court Congestion: Evidence from Indian Lower Courts”, Working Paper, University of Bonn.

Kang, Nimrit and Nitin Nayar, 2004, “The Evolution of Corporate Bankruptcy Law in India”, Money and Finance, Oct 03 – Mar 04.