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CORPORATE GOVERNANCE AND CORPORATE PERFORMANCE -
EXPECTATIONS AND REALITIES
by
Dr. YRK Reddy

(A synopsis of Pre-Convocation Address at
Symbiosis Group of Institutions, Pune, April 19th, 2003)

Backdrop:

Corporate governance has received a major fillip with the publication of the OECD principles in 1999, which was preceded by the CACG principles in 1998 that were the outcome of the earlier initiatives and the international concern for corporate collapses, capital market development, systemic risks and economic growth. The principles and recommendations of various committees acknowledge the importance of the Boards of Directors in directing and controlling the corporation, especially the publicly listed ones. The focus has been to ensure a structure and a system that will enable the boards to be independent of management; exercise due care and diligence in carrying out their responsibilities and be accountable to the shareholders at large. There is convergence in thinking that Corporate governance must assure equitable treatment of shareholders, uphold shareholder rights, foster stakeholder care particularly the creditors, have adequate disclosure and transparency and make boards responsible.

Popular Expectations:

It is assumed that a good board, a transparent system, proper accounting, reporting and disclosure practices and protection of shareholder rights stakeholder interests will ensure the success of company and save it from potential risks of collapse. It is against this background that the company laws, the stock exchange rules as well as the accounting and secretarial standards have been undergoing a major reform. Such reform and conformity with global standards are being considered important from the perspective of developing equity markets as well. Thus improved corporate governance standards are claimed to be pave the way for attracting international finance as also to improve domestic investor confidence and the related channeling of savings into the capital markets. Such flow it is expected will in turn spur economic growth and the resultant social benefits.

Annual reports and policies statements have started resounding the concern for Corporate Governance and the hope that improved Corporate Governance will be reflected in better shareholder value. The virtues and benefits of corporate governance have been further asserted with the now popular findings of Mc Kinsey.

The first study in 1996 assessed the willingness of institutional investors in USA to pay a premium for well governed companies. While 50% of the respondents were willing to pay a premium of an average of 16 per cent for well governed companies, 34% were unwilling. From the responses it was apparent that “value investors” (who pick undervalued stocks) were more inclined to pay a premium than the growth investors (those who pick hot scrips in hot industries), which indicates the potential relationship between the time horizon and Corporate Governance. In a later study, Mc Kinsey Co revealed that international investors were prepared to pay a premium for well governed companies in different parts of the world and that such premium could actually be as high as 28 per cent in Latin America (Venezuela); 27% in Asia (Indonesia) or 22% in Europe (Italy). Another study revealed that Asian boards have a poor rating compared to those in the USA and the UK (For instance 1.1 for Indonesia and 1.5 for Malaysia against 4.5 out of a scale of 5 for USA), which in some ways explains the reason for the high premium in the emerging markets. These studies and various policy statements from the regulators and industry leaders indicate an expectation that Corporate Governance should have positive impact on the shareholder value which indeed is one measure of corporate performance.

The relationship of Corporate Governance with corporate financial performance is less apparent. Firstly there are definitional issue of a serious nature relating to both Corporate Governance and Corporate Performance. Secondly, there are issues of temporal, sectoral and structural nature that have a bearing on the relationship.

The Definitional Issues:

The definitional issue surrounding Corporate Governance relate to the perspective from which it is being debated at the firm level. Corporate Governance normally looks at aspects of the structure of the board, accounting, reporting and disclosure practices. The regulators as well as professional self regulating organizations (SROs) also define Corporate Governance from the point of standards and structures. The premise is that a company, which is high on compliance with these standards, will enable pursuit of practices that might lead to good Corporate Governance. However, it is apparent, from the several failures for reasons other than fraud, that good compliance does not necessarily result in good sustainable performance. Hence, the debate on “conformance versus performance” – on the assumption that maximization of both is not possible and that there is an inevitable trade off between the two. It is for this reason that the competences, processes, values and ethics are considered important. These have been described as the “soft side” of Corporate Governance, which eludes standardization and measurement and yet is critical.

If Corporate Governance is considered from a comprehensive definition, there is a likelihood of including the strategic leadership provided by the board that prevents failures due to technological, technical, competitive and socio-demographic reasons. Boards which constantly assume the strategic role of debating competition, impeding forces, bench marking, positioning and repositioning and allocating resources appropriately and taking the right level of risks will obviously enable the company to learn faster and grow better than the others. Such a board/corporate governance system may make the company a learning and high performance one that competes and succeeds continuously on a sustainable basis. Such an ideal situation implies a definition of Corporate Governance that covers the hard side (structures, standards and systems), the soft side (processes, practices, values) and the strategic side (leadership, risk taking, achieving), which indeed is not yet prevalent.

The definition of Corporate Performance is daunting for the simple reason whether one must look at the shareholder value as derived from in the equity prices or the company’s financial results alone. While company financial results and equity prices will be positively correlated, the extent of such relationship is unlikely to be strong. Thus the PE ratios vary widely among sectors and companies. Those companies, which are fancied, by the brokers and traders obviously will have higher market value than the others.

The Temporal, Sectoral and Structural Challenges:

The other set of issues are relating to the temporal, sectoral and structural. The temporal issue is obviously related to the time frame in which we wish to examine this relationship. If Corporate Governance is defined narrowly from the hard side perspective it is probable that the relationship might get weaker over the longer term. On the other hand, a more comprehensive definition of Corporate Governance that includes the soft and the strategic sides might ensure better relationship both in the short and longer term, all other conditions being constant.

The sectoral issues relate to the industries and their inherent potential for performance or in Porterian language, industry attractiveness. Some industries may have high a very potential for performance within a given time frame for structural than efficiency reasons that may mask the quality of corporate governance. In India, the corporate performance of the NBFC sector during the 80’s and the software sector in the 90’s come to our mind as against those in the Steel, Cement and infrastructure industries that suffered prolonged recessionary conditions.

The structural issue I raised here is primarily relating to the ownership structures. Corporate Governance literature assumes wide holding, shareholder activism and a relatively high proportion of equity in the capital structure. This obviously is not the structure prevalent in the developing countries and some developed ones such as Japan and Germany. Consequently, Corporate Governance in unlisted or dominantly held or debt - dominant companies will be rated lower if one were to follow the Corporate Governance rating mechanism of the Standard & Poor or the Moody`s. Yet the Corporate Performance can be very high.

This leads us to imply that neither Corporate Governance nor Corporate Performance must be looked upon from a narrow construct. The relationship must be understood against a larger canvass. The causal factors, the variables that influence and intervene need further understanding. The complexity can be further illustrated by mentioning that Corporate Governance is also determined by such macro factors as the market infrastructure; creditors rights and their enforceability, the legal system, the information infrastructure and the like. A poor external system will give limited scope for Corporate Governance to impact Corporate Performance. I must confess to a lurking suspicion that compliance with the apparent principles of Corporate Governance may actually lag Corporate Performance than lead it, in developing countries especially if the external institutional conditions are weak. That is, well-performing companies may adopt corporate governance structures and system and join the rhetoric as a desirable fashion if it adds to the prospects of attracting capital or improving market sentiment. One such indication is the adoption of the popular board structures and reporting systems by the well performing 100 companies well ahead of the requirement and than the recession-hit ones.

Conclusion:

In conclusion, there is no denying the benefits and desirability of corporate governance in all its dimensions of the structures, systems, processes, values and strategic leadership. This will eventually result in company’s performance on a broader and sustainable basis than a short-term spike in financial results or the shareholder value. Consequently, Corporate Governance must be perceived as a non-negotiable hygiene condition than hunt for economic reasoning to invoke interest in it. Short-term expectations that narrowly defined corporate governance will indeed improve financial performance may lead to cynicism of the variety following the Enron collapse. The reality is that corporate governance and corporate performance are related in the same complex manner as health and happiness, with enough evidence to points to argue either way. Yet, like health for the life of any individual, a comprehensive adoption of corporate governance will breathe spirit into the economy and promote welfare that is increasingly threatened.

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