Any discussion of corporate governance is complicated by the
lack of a universally accepted definition of the term. Most
experts and commentators agree that governance is about the
management of a company and the extent to which stakeholders'
interests are respected and protected. However, there is often
disagreement over exactly who are the stakeholders. In the
Anglo-American market model (liquid stock markets and widely
dispersed shareholders), governance often focuses on the
interests of financial stakeholders, primarily shareholders. In
the continental European market model (less liquid stock
markets and cross shareholdings between industrial groups and
banks), governance is often extended to a broader range of
stakeholders, including employees and customers. This article
makes no attempt to judge either system. In fact, some experts
predict that the globalization of business and markets will
lead to a convergence of the various governance models.
Why has governance become increasingly important? It is
perhaps useful to look to history for a clue to the answer.
Before the early part of the 20th century, companies were
typically owned and managed by the same group of people. As
companies grew, the need for external finance resulted in an
increased number of owners (shareholders) and a need for
professional managers to manage the business on behalf of the
increased number of shareholders, who individually had little
influence over the company's management and the day-to-day
running of the business. This development brought a new problem
- the so-called agency problem - where the interests of the
company's managers (its agents) and its shareholders were not
always consistent. This is the governance problem - the problem
of ensuring that a company is managed, directed and controlled
in the interests of all its stakeholders.
Effective corporate governance is at the core of an
efficient market economy. Shareholders and other financial
stakeholders must have access to information and the ability to
influence and control management, through both internal
governance procedures and external legal and regulatory
mechanisms, in order to ensure that a company's assets are
being used in the interests of all financial stakeholders. This
is key in both developed and developing economies.
In developed markets, large institutional investors pay
considerable attention to corporate governance practices. Some
US pension funds, such as CalPERS and TIAA/CREFF, actively
pursue corporate reform through positions as big shareholders.
Every year, for example, CalPERS publishes a list of the best
and worst US corporate boards in an attempt to promote change.
As institutional investors own more than 50% of the equity of
US companies, companies are becoming much more sensitive to the
desires of these shareholders.
The market rewards companies that change. Some studies have
shown that efforts by a company to improve the quality of its
board have a significant and positive effect on share price.
Similarly, companies that continue to engage in activities that
place the interests of management over those of shareholders
tend to trade at a discount relative to other companies in
In emerging economies, the quality of corporate governance
can vary enormously. Indeed, poor governance or corrupt
governance (crony capitalism) negatively affects the returns on
investment in many countries and also contributes to larger,
systemic problems at national and regional levels. The scarcity
and poor quality of publicly available information, as well as
limited legal and regulatory recourse, frequently complicate
efforts by financial stakeholders to ensure that management is
acting in their interests.
The expropriation of outside investors (sometimes done
legally) is a big problem in corporate governance. Although
expropriation is not exclusive to emerging economies, it is
certainly much more prevalent there. Examples of expropriation
include cashflow diversion (transfer pricing), dilution of
minority shareholders, asset stripping and delay, or
non-payment, of dividends.
One of the aims of good governance should be to introduce
checks and balances to create the conditions necessary to
facilitate external finance. This view is apparently supported
by a number of studies including those by CLSA Emerging
Markets. Its first, entitled The Tide's Gone Out: Who's
Swimming Naked? and published in October 2000, evaluated the
corporate governance practices and performance of 115 large cap
stocks in 25 emerging markets. The study found that the price
of shares of those companies with high corporate governance
standards has been more resilient during market downturns.
The study commented: "...those (companies in the survey)
with weaker governance see their shares collapse when market
turmoil results in a higher discount for mismanagement.
Transparency, accountability, independence, fair treatment of
minorities, management discipline and responsibility - key
features of good governance - are crucial in assessing and
reducing investment risks in emerging markets." Similarly, the
study also showed that the price of the shares of companies
with good governance have significantly outperformed. Taking
this a stage further, higher share prices should therefore lead
to a reduction in the overall cost of capital.
Later studies by CLSA in 2002 and 2003 have reinforced these
earlier findings. CLSA's most recent study published in May
2003, confirmed that corporate governance remains a key to
investment decisions and valuation metrics at both the macro
and micro levels.
Standard & Poor's own Transparency & Disclosure
study covering 1,600 global companies found a correlation
between high standards of transparency (often a leading
indicator of higher governance standards) and price-to-book
ratios, reinforcing the view that the market rewards those
companies with higher standards.
On a macro level, other studies have shown that in countries
where higher investor protection measures existed, and where
corporate governance standards were higher, the impact of
economic crises was, relatively speaking, less. Studies in the
US have examined the depreciation of currencies and the decline
of the stock markets in a number of emerging economies during
the Asian crisis of 1997-98. The studies revealed that
countries with higher standards of investor protection were,
relatively speaking, better insulated against market turmoil
than those countries where investor protection laws were
The annual survey of global institutional investors by the
management consulting firm, McKinsey, also found that these
institutional investors said that they would be willing to pay
a significant premium for the shares of companies that they
knew to be well-governed. In fact, some investors stated that
good governance practice was a key determinant of whether they
would invest in a particular company or not. Not surprisingly,
the average premium differs from country to country. Companies
domiciled in countries with high governance standards can
expect to pay significantly less than companies in countries
where standards are low.
Similarly, companies with contrasting governance practices
domiciled in the same country can expect significantly
different premiums from investors. Even in the UK, generally
recognized as one of the stronger environments for corporate
governance, investors say they will pay up to 14% more for the
shares of well-governed companies.
McKinsey's findings are consistent with good risk management
practices, where logic dictates that investors should pay a
premium to reduce risk (in this case, risk associated with poor
governance practices). Conversely, these investors should
expect to receive a discount for assuming greater risk.
On a more fundamental basis, investors often cite poor
corporate governance practices as the reason for not investing
at all, or for reducing the level of investment in a particular
For all the above reasons, the need to introduce standards
of corporate governance and build greater transparency in
emerging markets is increasingly recognized. The OECD and
multilateral development banks, for example, are actively
seeking to improve awareness and conceptual understanding of
corporate governance, and to encourage both governments and
companies to take practical steps to improve corporate
At the government level, emphasis is placed on encouraging
the building of a strong legal and regulatory environment, and
this includes evaluating the effectiveness and enforceability
of existing laws, as well as the level of transparency and
disclosure required by the market.
At the company level, this means adapting governance
practices consistent with increasingly accepted principles of
corporate governance in global markets. However, there is no
one model of corporate governance that works in all countries
and in all companies. Indeed there exist many different codes
of best practice that take into account differing legislation,
board structures and business practices in particular
countries. However, there are standards that can apply across a
broad range of legal, political and economic environments. For
example, the Business Sector Advisory Group on Corporate
Governance to the OECD has articulated a set of core principles
in corporate governance practices that are relevant across a
range of jurisdictions. These are: fairness, transparency,
accountability and responsibility.
MEASURING CORPORATE GOVERNANCE
In 2001, Standard & Poor's launched a new service,
Corporate Governance Scores, to evaluate corporate governance
practices, both at a country and a company level. The aim was
to introduce a principles-based approach to governance
analysis, focusing on substance rather than form, and to avoid
the models-based, box-ticking approach often adopted by
The analysis was divided into micro and macro aspects of
Firm level analysis evaluates corporate governance practices
at individual companies. Using a synthesis of the OECD's and
other international codes and guidelines of corporate
governance practices as cornerstones of the scoring method,
Standard & Poor's assigns scores to a company's overall
governance practices and four individual components (see
A company's Corporate Governance Score (CGS) reflects
Standard and Poor's assessment of a company's corporate
governance practices and policies and the extent to which these
serve the interests of the company's financial stakeholders,
with an emphasis on shareholders' interests. (For the purposes
of the CGS, corporate governance encompasses the interactions
between a company's management and its board of directors,
shareholders and other financial stakeholders.)
A CGS is awarded on a scale from CGS-1 (lowest) to CGS-10
(highest). In addition, the four components, described below,
all contribute to the CGS and receive individual scores from 1
(lowest) to 10 (highest).
Standard & Poor's analyzes the four main components, and
their sub-categories, to evaluate the corporate governance
standards of individual companies. These four components and
the sub categories are as follows:
Component 1 - ownership structure and external
- transparency of ownership;
- ownership concentration and the influence of external
Component 2 - shareholder rights and stakeholder
- shareholder meeting and voting procedures;
- stakeholder relations (including non-financial
- ownership rights and takeover defences.
Component 3 - transparency, disclosure and
- content of public disclosure;
- timing of, and access to, public disclosure;
- audit process.
Component 4 - board structure and effectiveness
- board structure and independence;
- role and effectiveness of board;
- directors and senior executive compensation.
COUNTRY GOVERNANCE ASSESSMENT
The purpose of country analysis is to determine the extent
to which external forces at the macro level support the
internal governance structures and processes at the company
The external environment can be important in motivating good
or bad internal governance practices by individual companies.
It is also of importance in defining:
- The rights of financial stakeholders and how these have
an impact on the company's relations with its financial
- How effectively the relevant infrastructure in a given
country encourages and protects these rights.
The first attempts to clarify what stakeholder rights exist
as defined by legislation and regulatory practice. The second
addresses the relevance of these rights in practice.
In addition to an assessment of pertinent laws and
regulations, the analytical process may involve discussions
with investors, company directors, lawyers, accountants,
regulators, stock exchange officials, economists and relevant
The four main areas of focus in this analysis are:
- legal infrastructure;
- information infrastructure; and
- market infrastructure.
The country analysis includes assessments of each
The Country Governance Evaluation reflects the degree to
which the legal and regulatory, and informational and market
environments provide a supportive infrastructure for effective
A strong country support environment will not mean that an
individual company from that country will automatically be
highly scored itself. There is no floor because an individual
company in a positively assessed country can receive a low CGS
if so warranted.
Conversely, because the analysis focuses on what a company
does, rather than what is required by law or regulation and
benchmarks a company's corporate governance standards to codes
and guidelines of good corporate governance practices, there is
no sovereign constraint. A weak environment will not
necessarily mean that a company will receive a low CGS. It is
entirely feasible that a well-governed company in a negatively
assessed country may receive a high CGS.
Although Standard & Poor's Governance Services analyzes
individual countries, it does not assign country governance
scores. However, Standard & Poor's sovereign credit ratings
can serve as a proxy for governance risk at the country level.
Standard & Poor's own research has identified a remarkably
close correlation between these sovereign credit ratings and
its own and others' analysis of country governance risks.
Corporate Governance Scores allow the comparison of
individual companies within a national context as well as
comparisons of companies in different jurisdictions. This
concept is reflected in the graphic below which isolates
country and individual firm governance standards on a two
dimensional matrix. While Firm A and Firm B may have a similar
level of overall governance standards, the fact that Firm A is
in a more protective country environment than Firm B suggests
that the greatest investor protection is for Firm A given that
it is domiciled in a country with a more robust supportive
environment for good governance practice.
There is limited empirical evidence linking individual
company scores with the country environment. However, it is
reasonable to assume that the two are positively correlated. In
other words, high governance standards might be expected in
countries that reflect strong legal, regulatory and
informational infrastructures; the opposite would be the case
in countries that score low in this macro assessment. This is
reflected in the hypothetical distribution reflected below.
This hypothetical distribution is broadly consistent with
Standard & Poor's own experience in corporate governance
However, it is important to note that it is also reasonable
to expect outliers (that is, cases of strong firm governance in
weak country environments) and vice versa. In many ways these
outliers are the most interesting situations to assess, and
need to be properly identified.
In this context this two dimensional matrix can be further
subdivided into four quadrants, as reflected in the diagram
The north-east and south-west quadrants might be labelled
the Expected Distribution because they reflect the assumption
of a positive correlation between company governance standards
and the overall country governance environment. The north-west
and south-east quadrants reflect the outliers, and can be
divided into two very different groups:
Under-achievers: companies in strong country environments
whose own governance standards have not met high standards (for
example Enron, WorldCom, HealthSouth in the US).
Over-achievers: companies in weak country environments whose
own governance standards can be viewed as high relative to the
country of domicile (for example Infosys in India).
In this schema, clearly the under-achievers will have little
or no incentive to have their governance standards publicly
scored. However, the overachievers - mostly from emerging
economies - are likely to have the greatest interest in
receiving a governance score so as to differentiate their firm
positively from local peers with lower governance
Standard & Poor's
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