The Hindu Business Line : Goodness is in fashion in corporate governance

CORPORATIONS today touch our lives, from the food we eat to the quality of air we breathe. Although the culture of a firm is determined by the tone set by its top management and the independence and judgment by gatekeepers such as directors, auditors and attorneys, corporate behaviour, in many ways, is regulated by its multiple stakeholders.

The degree of tolerance to ethical misgivings set the fabric of the entire corporate structure. In some cases, it permeates through different countries and markets where a company operates. Such is the reach of a global organisation, today.

Some MNC brands and companies, while becoming a generic term for the product they manufacture, also become vehicles of aspirational human ideals such as honesty, fair play, and so on. But, at times, some brands also become the targets of mass protests as a symbol of imperialistic behaviour of the home country where the company has its headquarters.

Worldwide protests against unethical practices followed by companies in any part of the world — or even the threat of such protests — force companies to align grandiose mission statements closely with actual conduct on ground level. Examples that immediately come to mind are MNCs such as Nike and GAP that were forced by widespread protests in their home markets to publicly demonstrate their commitment towards fair labour practices followed on the other side of the globe in countries such as Pakistan, Indonesia, India, and so on.

The message to companies is clear: keep to the straight and narrow or face the consequences.

Sam DiPiazza, the Chairman of PricewaterhouseCoopers, recently wrote in Financial Times of London, "Rebuilding trust in public companies remains an arduous process involving significant expenditures.

Ultimately, these expenditures will be judged not by CEOs, regulators or commentators but by the investor. The investor will give a higher valuation to those companies that embrace good governance and effective risk management — not because they have satisfied requirements, but because those that have turned this new era of compliance into a better tool for taking risks will turn out to be the winners in their markets."

Regulations such as the Sarbanes-Oxley Act and its manifestation in India as an amendment to Clause 49 of the listing agreement to usher in corporate governance by making corporations, its management and board to take specific action and be responsible for maintaining fair internal control and reporting practices. These regulations form the minimum acceptable standards of corporate behaviour. Regulations are triggered when business enterprises are unable to adhere to business ethics and morals, through voluntary self-governance mechanism. Corporations need to do their own soul searching to determine where in the scale of respectability they wish to place themselves.

A corporation that focuses on ensuring the long-term success of its business is more likely to implement sustainable risk and control mechanisms than one that is primarily concerned with achieving short-term goals.

In late 2004, PricewaterhouseCoopers and Financial Times did a survey on the `World's Most Respected Companies' (see Table for results).

Value creation activities by enterprises move within different value drivers — both financial or GAAP related and non-financial measures.

Irrespective of how the measurement parameters on this grid change, companies that create value are respected and also have effective corporate governance along with high social responsibilities.

But do high levels of corporate governance pay? What would make the elephant dance?

A study by Paul Gompers, Lizzi and Metrick, titled `Corporate Governance and Equity Prices', concludes that an investor that sold shares in publicly traded US companies with the weakest shareholder rights and bought those with the strongest would have earned "abnormal" returns of 8.5 per cent a year during the sample period.

The study analyses 1,500 companies and ranks them in deciles based on 24 distinct corporate governance provisions.

The most "dictatorial" firms were less profitable, had lower sales growth and the returns on such firms not surprisingly trailed those of the "democratic" portfolio by an average of 8.5 per cent a year.

Similar studies by Rob Bauer and Nadja Guenster showed empirical evidence of positive correlation of better performance in the stock markets by better governed companies in the Euro zone.

In fact, they go on to say that companies that increase 1 per cent in Deminor Rating (a European corporate governance rating agency) translates to 0.47 per cent increase in their market value.

GovernanceMetrics International said its latest data on 2,588 global companies found that 26 companies receiving the highest score of 10 outperformed the Standard & Poor's 500 stock index total return by 10 per cent over the last five years.

In the Asian markets, a CLSA (Credit Lyonnais Securities Asia) report, `Saints and Sinners — Who Has Got Religion', analysed results of over 495 companies in the emerging markets and these studies showed that in many markets, companies with good corporate governance have outperformed their indices in recent years and moved to valuation premia.

Companies with governance are also those with high ROE (return on equity) and the largest value creators on an EVA (economic value added) analysis.

The report further states that of the 100 largest companies, firms that garnered the top five scores for corporate governance were HSBC (Hong Kong), Infosys (India), Singapore Airlines (Singapore), Li & Fung (Hong Kong) and Richemont (South Africa).

The biggest change in the last decade has been institutionalising of the shareholders. Some of these investors issue what is called `focus list', with issues related to performance or governance that need management attention.

The best known focus list is issued by CalPERS, the California based pension fund. The `CalPERS effect' showed that companies included in the focus list substantially outperformed in the five years after their listing.

The study supports the view that the process of publicising problems of the companies, including the governance issues, and, where appropriate, actively engaging the companies to address such failings can improve their performance.

The concept of governance in India, such as it is, is brought about by a few companies themselves and to an extent by foreign institutional investors, including venture capitalists.

Firms that benchmark themselves internationally have opted for disclosure standards that are far more rigorous than those required in India. For instance, companies seeking to list on NYSE or NASDAQ practice `functional convergence' in corporate governance standards — that is, adopt standards of the foreign country on which it seeks to list, which may be stricter than home country requirements.

Companies voluntarily started publishing financial statements supposedly prepared under US GAAP.

In a study of Indian corporate governance culture, two Harvard Business School (HBS) professors, Tarun Khanna and Krishna Palepu, focussed especially on Infosys.

They found that exposure to global capital markets is a result, rather than a cause, of Infosys' decision to adopt world corporate governance standards. And the desire for good governance at Infosys, in turn, is its need to attract talent with truly worldwide options which, in turn, is necessitated by fierce global product market competition.

The HBS authors do not find much of a role for capital markets as drivers of the process of convergence of corporate governance.

On the contrary, Infosys and other Indian software firms such as Wipro and Satyam accessed global capital markets long after their exposure to global product and global talent markets had driven them to adopt good corporate governance practices.

Finally, the standards of corporate governance at some of these visionary companies are the exception, rather than the rule in India, with most firms in the so-called sunrise information technology industry also falling far short of the benchmark.

Any research based on governance rankings is based on standards that attach different weights to various items in the matrix.

These weights and their interpretation of the results vary between studies. On the other hand, opinion-based research relies on circumstantial and subjective evidence to reach a conclusion.

Despite their shortcomings, these results, read together with all the other research, provide firm support to the fact that improved corporate governance systems increase shareholder value for enterprises.

(The authors are chartered accountants.)

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