Author: | Published: 9 Oct 2003
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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 their sector.

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 weak.

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 stock.

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 governance practices.

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.


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 others.

The analysis was divided into micro and macro aspects of governance:

Company analysis

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 below).

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 influences


  • transparency of ownership;
  • ownership concentration and the influence of external stakeholders.

Component 2 - shareholder rights and stakeholder relations


  • shareholder meeting and voting procedures;
  • stakeholder relations (including non-financial stakeholders);
  • ownership rights and takeover defences.

Component 3 - transparency, disclosure and audit


  • 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.


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 level.

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 stakeholders.
  • 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 trade associations.

The four main areas of focus in this analysis are:

  • legal infrastructure;
  • regulation;
  • information infrastructure; and
  • market infrastructure.

The country analysis includes assessments of each factor.

The Country Governance Evaluation reflects the degree to which the legal and regulatory, and informational and market environments provide a supportive infrastructure for effective corporate governance.

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 scoring.

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 below.

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 standards.

Standard & Poor's
Nick Bradley
Governance Services
18 Finsbury Circus
London EC2M 7NJ
United Kingdom