Many a time, we come across a business which is of a good quality but the management has conducted itself in the past in ways which do not fully conform to ethical and legal standards.
Should we reject that idea? On what parameters should we decide?
Niti and Nyaya
In Sanskrit, both these words denote justice. However, according to philosophical texts, there is a subtle difference between the two. “Niti” stands for moral conduct, correctness of behaviour and is abstract in nature. “Nyaya” stands for rules and procedures and is absolute in nature.
A king had a wise minister who always spoke the truth. The king once decided to put-down his minister. He showed his closed fist to the minister and said “You are so wise and you always speak the truth. In my fist, there is an ant. Tell me if it’s dead or alive.” The minister thought for a moment and replied that the ant is dead. The king laughed and feeling victorious- opened his fist. The ant was alive and walking. The king told the minister that he had been proved wrong. The minister remained silent.
Later on, one of the minister’s friend in the court asked if he knew that the ant was alive. The minister said, “Yes, I knew. But had I spoken the truth, the king would have closed his fist tighter and killed the ant. In order to save the life of the ant, I had to side with Niti (moral conduct) at the cost of Nyaya (legal conduct).”
Let’s look at some examples of management actions through the lenses of Niti and Nyaya.
1. A pharma company has a monopoly on some drugs and raises prices exorbitantly. Assuming that the drugs were not under any price regulation, the company was well within its right to raise the prices. So, Nyaya (legal conduct) was intact.
But raising the prices beyond a reasonable limit causes undue hardships to families who needed the medicines. Did the company’s management behave with the correct Niti?
2. A company decides to pursue a buyback at a cheap price with negative consent from the minority shareholders and promoters do not participate in the buyback. Negative consent means that if the shareholders don’t opt out, it would be deemed that they agree to the buyback. Minority shareholders who didn’t understand the matter completely found their shares bought back (stolen) from their accounts at low prices. The company has followed all due legal procedures and hence has Nyaya on its side. But did it have Niti on its side?
3. Munger once bought a business and had a couple of widows on other side of the transaction. Unaware about financial matters, the widows quoted a lower price than what Munger had calculated. He decided not to take advantage of their ignorance and paid the higher price. He ignored the rule-based conduct in favour of an overarching moral conduct.
4. A company under debt reconstruction gets settlement terms from all the creditors. There are hundreds of small depositors who had put their savings into the company’s deposits. Realising that even though under financial stress, it can still pay the small depositors, the company decides to pay in full to them. An example where the management is guided by the moral conduct and not by the legal conduct alone.
During our investing careers, we will come across many such permutations and combinations of intermeshed legal and moral conducts.
1. When a management runs a business both with Niti and Nyaya on its side, one can quickly conclude that you have got the right set of partners.
2. One can also immediately conclude when neither Niti nor Nyaya is present. Don’t venture close to such managements. You will lose both- character and money.
3. If the management has been guided by a higher moral conduct at the expense of rules, look carefully. If you conclude that it is indeed the case, then it is a very good management to partner with.
4. The tough situations are the ones where a management has followed all legal procedures but their actions do not pass the test of moral conduct. What to do in such cases?
I think about them in the following way:
- Is the issue-at-hand going to damage the core business of the company?
- What % of revenues or value pertains to this issue at hand?
If the issue is small relative to the revenues/value of the business, I would tend to take it in my stride and not reject the idea outrightly.
- Does the issue make me question the basic DNA of the management?
Irrespective of the % contribution to revenues/ value, if the basic DNA of the management becomes questionable, I would stay away and not partner with them. Dubious schemes of arrangement and related party transactions are fertile grounds for such behaviour.
- Are there more than one distinct corporate governance issues?
Judging corporate governance practices in a business is quite a subjective call. Two well-meaning investors can have different perspectives on the same issue. It depends on one’s own tolerance level, risk appetite and overall attitude towards investing.
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