of a number of corporate scandals in recent times. The scandals left .... which seems to be blotted with many scandals from Enron, Tyco, Adelphia, Qwest,.
Capital Market Development through Corporate Governance
Anurag Pahuja* Dr. B.S. Bhatia** It is almost a truism that the adequacy and the quality of corporate governance shape the growth and the future of any capital market and economy. Strong corporate governance is indispensable to resilient and vibrant capital markets and is an important instrument of investor protection. Corporate Governance, a buzzword today, is a result of a number of corporate scandals in recent times. The scandals left investors in a totally shattered position. Why to invest? Where to invest? And how to invest securely? To answer these questions, a step towards transparent and integrated disclosure practices was taken. Though disclosure practices have been a matter of concern for long yet it has started taking a very well defined shape just now from voluntary to mandatory disclosures, from narrower to wider horizons and from window dressing to total transparency in the form of good corporate governance.
The major objective of this paper is to analyze the role of corporate governance in promoting investor confidence and developing capital market. An attempt is also being made to examine the relationship, if any, between corporate governance and performance of the company. For this purpose, the paper has been divided into six sections. The first section deals with an introduction to the concept of corporate governance and its need followed by an overview of Indian Capital Market in the second section. In the third and fourth section, the role of corporate governance in boosting investor confidence and attributes of good corporate governance have been examined respectively. Section five examines the relationship between corporate governance and performance of organizations in capital market. Section six finds out the emerging issues in corporate governance followed by the conclusion in the last section.
*- Faculty-Finance, Apeejay Institute of Management **- Director General, RIMT-IMCT, Mandi Gobindgarh
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1. Corporate Governance: An Introduction Corporate Governance has succeeded in attracting a good deal of public interest because of its importance for the economic health of corporations and the welfare of society, in general. However, the concept of corporate governance is defined in several ways because it potentially covers the entire gamut of activities having direct or indirect influence on the financial health of the corporate entities. As a result, different people have come up with different definitions, which basically reflect their special interests in the field.
The earliest definition of Corporate Governance by the Economist and Noble laureate Milton Friedman is that “Corporate Governance is to conduct the business in accordance with owner or shareholders‟ desires, which generally will be to make as much money as possible, while conforming to the basic rules of the society embodied in law and local customs”.
Over a period of time, the definition of Corporate Governance has been widened. It now encompasses the interests of not only the shareholders but also many stakeholders. As per SEBI (Kumar Mangalam Birla) Report on Corporate Governance, “fundamental objective of corporate governance is the „enhancement of the long-term shareholder value while at the same time protecting the interests of other stakeholders.”
In the report of the Rahul Bajaj Committee on Corporate Governance in India, Shekar Datta, the then president of CII said that “Corporate Governance” is a phrase which implies transparency of management systems in business and industry, be it private sector, public sector or the financial institutions – all of which are corporate entities. Just as industry seeks transparency in government policies and procedures, so, also, the debate on Corporate Governance seeks transparency in the corporate sector.
1.1 Need for Corporate Governance
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Corporate Governance depicting an environment of trust, ethics, moral values and confidence, is a synergistic effort of all the constituents of society. The stakeholders including government through legislative measures, professionals through their value added and independent services, service providers and the corporate sector through their thrust to grow and flourish, contribute to good governance level.
The need for better governance of the organizations arose because of divorce between the ownership and management in the corporate sector enterprises, the increasing complexities and size of organizations, the growing awareness of investors and their keen interest in the working of business enterprises and the changing socio-economic and political environment in the country.
The corporate organizations generally raise their capital from the public. The investors would normally like that the management makes a fair and adequate disclosure of the state of affairs. In an “Investor Opinion Survey on Corporate Governance” conducted by McKinsey & Company in June 2000, it was found that more than 80% of the investors were willing to pay a premium for the shares of a well-governed company than for a poorly governed company with comparable financial performance.1
2. Indian Capital Market: An Overview In terms of reforms and development, the Indian financial sector, more particularly, the Indian capital market has been the fastest to grab every opportunity presented by the paradigm shift in India‟s economic policy. The furious developmental activities have put the Indian Capital Market almost at par with the best in the world, in terms of its structure, systems and regulation. Still there are inadequacies and flaws because three key ingredients namely adequate supervision, strict accountability, and appropriate punishment are missing. As a result, the markets have remained shallow and diminutive and have lurched from one financial scandal to another over the last few years. Every policy change in the liberalization process was pounced upon by unscrupulous companies, diverting thousands of crores of rupees to themselves with the help of an
Electronic copy available at: http://ssrn.com/abstract=2622965
entourage of investment bankers and consultants. In the process, retail investors have been the biggest losers and the effect of their disenchantment is visible in the slow growth of India‟s investor population. China has over 25 million investors, while India, with all its rapid development and its 130- year old stock exchange culture has only 19 million investors.2 The world over, a number of countries have undergone investor confidence crisis. In South Africa, listing scam has resulted in private investors losing heavily in their stock market. Companies with no earnings record and inexperienced directors got listed on stock exchange. Their only objective was profit making out of inflated market price. The net result was private investors losing confidence in the market.3 The Corporate America, which seems to be blotted with many scandals from Enron, Tyco, Adelphia, Qwest, Global Crossing to WorldCom and AOL Time warner, is no exception to this investor confidence crisis.
3. Corporate Governance and investor Confidence Corporate governance issues have gained momentum world wide in recent decades in the wake of these financial scams or corporate failures, as these tend to highlight the need for tighter surveillance over corporate behavior. Whenever companies fail to follow good corporate practices no other stakeholders are as badly or immediately affected as minority investors. They are the weakest segment of the capital market and rarely able to protect their own interests and investments. Here arises the need for good corporate governance. In the words of Shleifer and Vishny4 (1997), “Corporate Governance is the way by which suppliers of finance to corporations assure themselves of getting a return on their investment.”
It is evident that investor confidence pays an important role in the economic development of a country. Integrity of the financial markets and economic well being of any country depend on corporate accountability and investor confidence. The Global concern today is to restore the confidence of the average investor that capital markets are safer through sending a strong signal to corporate wrongdoers. Transparency in operations, strong
financial system and proper management of crises are the issues, which add up to a stronger system and boost up the morale of investors. And all these issues are addressed together under the purview of good corporate governance.
4. Attributes of Good corporate governance Good corporate governance is the extent to which companies are run in an open and honest manner- is important for overall market confidence, the efficiency of international capital allocation, the renewal of countries‟ industrial bases, and ultimately the nations‟ overall wealth and welfare.
Characteristics of good CG High level of transparency & disclosures Integrity of accounts Appropriate governance structure Strong & independent Board of Directors Care for minority shareholders Active Board Committees
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Fig.1- Characteristics of good CG
4.1 Pillars of Good Corporate Governance Many companies after successfully creating value for their shareholders satisfy themselves that they are observing good governance practices. Creating value for shareholder is a necessity but not the sufficient condition for good corporate governance practices. Good corporate governance is based on three pillars. These are:
a. Transparency of operations
This means adequate and timely dissemination of information by a company of its operations to its stakeholders. These disclosures need not necessarily be governed by the rules and regulations imposed by a stock exchange or a security market regulator. The company on its own has to come out with adequate and timely disclosures of honest anticipation or actual happening of material events affecting the value of the company.
Good Corporate Governance
Transparency Of operations
Accountability towards Shareholders
Fairness in Dealings
Fig. 2 - Pillars of good corporate governance
b. Accountability towards stakeholders
This means the board is responsible and accountable to its various stakeholders. The issue is: to which class of stakeholders the board should primarily responsible? Good corporate governance practices warrant that the companies should adequately compensate and take care of the interests of each class of stakeholders. In United States, the board‟s primary
responsibility is presumed towards the shareholders. In Germany and some of the East Asian economies, the favored stakeholders may be employees, suppliers, or lenders etc.
c. Fairness in dealing
This is essentially related to ethical behavior of the companies. In their attempt to achieve higher returns in the short term, companies often indulge in unethical or unfair practices, like tax evasion, exploiting the labour or the supplier, willful default in servicing the debt etc. This is not restricted only at the company level, but is also applicable to inter se relationship among the shareholders. For example, a few promoter management groups have been observed to indulge in siphoning off corporate resources to their private associates by awarding corporate contracts at artificially high prices, oppressing the minority shareholders. A well governed corporate cannot be built on the foundations of unethical means.
5. Corporate Governance and Capital Market: Empirical Evidence A number of studies have been conducted which directly or indirectly establish a linkage between Corporate Governance and performance of companies in Capital Market. According to OECD, only companies with credible and well-understood corporate governance practices would be able to attract long-term capital. Good corporate governance provides the company with a stable base from which to operate with the necessary checks and balances to better withstand economic vagaries and market movements. There is no doubt that the level of awareness and understanding of corporate governance issues not just as concepts but as practical tools of good management and shareholder value enhancement has increased at an accelerated pace. In essence it has become an integral part of the risk management tool kit. In a recent study5 of 398 firms from Indonesia, Korea, Malaysia, the Philippines, and Thailand, it was found that differences in variables related to corporate governance had a strong impact on firm performance during the East Asian financial crisis of 1997¯1998.
The study showed significantly better stock price performance was associated with firms that had indicators of higher disclosure quality, had higher outside ownership concentration, and firms that were focused rather than diversified. Paul Gompers 6 of Harvard Business School and others have conducted a study to on CG and Equity Prices. For the purpose of the study, a „Governance Index‟ was calculated for 1500 large firms during 1990s and it was found that corporate governance was strongly correlated with stock returns. An investment strategy was devised that bought firms in the lst decile (strongest CG) and sold firms in the 10th decile (lowest CG) earned the index by 8.5% during that period . A Study by Japan Corporate Governance Research Institute7 devised the JCG Index, which measures corporate governance in Japanese firms. Their study found that high JCG Index firms achieved superior performance, as measured by ROA, ROE, Stock Returns etc. A Study by Wolfganag Dorbetz8 , University of Basel on Corporate Governance and Expected Stock Returns devised an investment strategy that bought high-CGR firms and sold low CGR firms and earned excess returns of 12% compared to the DAX 100 during 1998-2000. CLSA‟s CG Watch Report9 (2002) moved Malaysia up in its ratings, highlighting in particular, the revamped listing requirements, increased emphasis on minority shareholders, government efforts to separate ownership from management and increased enforcement efforts. Of particular interest, is their finding that high corporate governance stocks have outperformed the Kuala Lumpur Composite Index (KLCI) by 60.4% over five years to end 2001. The report finds such stocks command “premium valuations for good corporate governance, well-managed operations and entrenched market positions”. In a Global Investor Opinion Survey10 (2002), McKinsey & Company found that corporate governance is at the heart of investment decisions. It was found that Investors put corporate governance at par with financial indicators when evaluating investment
decisions and a majority of investors are prepared to pay a premium ranging from 12% to over 30% for companies exhibiting high governance standards.
6. Emerging Issues 6.1 Clause 49 in the Listing agreement: An initiative by SEBI When capital markets systematically open up to both domestic and foreign financial flows, corporate governance requires dynamic supervision and effective vigilance of the regulator in order to protect and further the interests of investors. In this regard, on May 7, 1999, The Securities Exchange Board of India (SEBI) appointed a Committee on Corporate Governance under the chairmanship of Shri Kumar Mangalam Birla, to promote and raise the standards of Corporate Governance. The committee suggested mandatory and the non-mandatory recommendations in its report. The mandatory recommendations of the committee were made quasi-regulation by inserting them as Clause 49 in Listing Agreement of the stock exchanges in India. In 2003, SEBI constituted another Committee on Corporate Governance under the Chairmanship of Shri N. R. Narayana Murthy, which recommended certain amendments in Clause 49 of the Listing Agreement. The amendments were introduced in the revised clause, which has enabled SEBI to inculcate new culture of good governance in Indian companies. By introducing the revised Clause 49, SEBI has upgraded the information supply by companies to the capital market. It has also indirectly improved governance processes in the company through stricter role of audit committee, independent directors, transparency in compensation and disclosures, related party transactions, accounting, utilization of public issue proceeds, risk management systems, etc. 6.2 Changed Focus An interesting dynamic of the global trend has been the changing focus and priorities in dealing with corporate governance. In India too, the focus is changing from strong regulatory framework to one that places emphasis on self-regulation and market regulation.
6.3 Corporate Governance Dividend Empirical evidence suggests that companies demonstrating good governance practices are becoming more attractive to investors and the concept of the „corporate governance dividend‟ is becoming a reality. For investors, good corporate governance means a more transparent and accountable market with higher standards of disclosure on which they may base their investment decisions and ensure good returns.
7. Conclusion Recent corporate failures of once mighty corporates have proved to be a huge wake up call for all constituents of corporate governance process including the governments and the regulators. This indicated the urgency for capital market regulators to put in place systems to avoid the recurrence of distasteful incidences of questionable corporate events, which not only leave the investors high and dry and erode their trust in the institution of business, but also affect the national economies and public at large. And it has been proved through empirical evidence that the virtue of good corporate governance has been able to restore the confidence of once shattered investors. It can be concluded that though good corporate governance is certainly not a panacea for all the economic woes of a company and indeed the capital market, yet it provides a strong and stable infrastructure to support the activities of a company and the market place. It provides companies with the ability at the worst, to survive the various challenges facing them.
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