The recent number of corporate failures in the US and Europe, the almost daily articles regarding hefty pay-outs to directors and senior managers, and the questions regarding the suitability of accounting practices are all bringing corporate governance issues closer to home. Have the corporate governance practices of companies in developed markets worsened substantially in recent years? or have market participants finally started to pay attention to issues that they previously chose to ignore?
The answer is probably somewhere in between, but the important point is that corporate governance as a risk class is here, and it is here to stay. Standard & Poor's own research in major financial centres points to the fact that assessing corporate governance is increasingly necessary for many investors when they are evaluating potential investments or lending opportunities. If investors are unable to evaluate that risk, they are likely to be reluctant to invest, or will require a significant premium to mitigate the unknown. Where the investor is unable to evaluate the risks associated with governance practices, equities may be incorrectly priced. In some markets, this can disadvantage the company and raise the cost of capital.
Furthermore, corporate governance risk arises from the directors' and senior managers' ability to identify and mitigate risks related to the company. Inadequate risk management often results in errors of judgment, operating losses or legal action, all of which can have a substantial negative affect on shareholders value. Where poor governance practices are suspected, a company's share price will often trade well below the real economic value of the enterprise. For example, the market capitalisation of one major natural resources company suspected of shareholder abuses is 90% less than that of its Western equivalent, although its reserves are six times greater.
Effective corporate governance lies 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. This means that there has to be both effective internal governance procedures and external legal and regulatory mechanisms. Only then can there be any assurance that a company's assets are being used in the interests of all financial stakeholders. This is important in both developed and developing economies.
Corporate governance as a risk
In developed markets, large institutional investors pay considerable attention to corporate governance practices and their associated risks. In the UK, Hermes is particularly active in this respect. In the US, some pension funds, such as CalPERS and TIAA/CREFF, actively pursue corporate reform through their power as major shareholders. Every year, for example, in an attempt to promote change, CalPERS publishes a list of the best and worst US corporate boards. Wilshire Associates, the US index compiler, was quoted in a recent Financial Times article as pointing to the 'CalPERS effect', where companies that have been singled out for criticism by the Californian pension fund and have then taken positive steps, have seen a subsequent rise in their share price. Activism has an effect, it seems.
Dana F Kopper, a senior vice president and the national practice leader of FINPRO Consulting at J & H Marsh & McLennan and BoardWorks, in his paper Corporate Governance and Risk Mitigation: Internal Strategies for External Risks, points out the strong connection between effective corporate governance and improved organisational performance. He states that a board composition which includes independent directors and is accountable is one of the issues that have been shown to enhance performance and reduce risk. Kopper's paper further states: 'A 1995 University of North Carolina doctoral thesis offered strong quantitative support for the proposition that there is a correlation between board composition and incidences of fraud. Its main conclusion is that the greater the number of outside independent directors, the lower the probability of fraud.' However, recent corporate failures have proved that having a majority of independent directors on the board is not the only condition that needs to be fulfilled. The information necessary for directors to make informed decisions is of great importance, and there should be a clear understanding of what information should be provided to the board of directors, and how often they should get it.
Further interesting results come from a recent study of 1,500 US companies by Paul Gompers, Joy Ishii and Andrew Metrick (Corporate Governance and Equity Prices). This study found a 'striking relationship between corporate governance and stock returns'. It goes on to say that 'an investment strategy that bought the firms in the lowest decile of the index (strongest shareholder rights) and sold the firms in the highest decile (weakest shareholder rights) would have earned abnormal returns of 8.5% per year'.
My own company defines corporate governance as the way a company is organised and managed to ensure that all financial stakeholders receive their fair share of a company's earnings and assets. The subject is discussed more frequently than ever before by financial commentators, regulators, market participants and analysts. Hardly a day goes by without a conference, launch of a new code or pronouncement on the subject. At the last count there were approaching 100 different corporate governance codes and guidelines around the world.
Measuring the risk
A major problem is the lack of established benchmarks for comparison of corporate governance practices. Recently, Standard & Poor's launched a service to calibrate the extent to which companies conform to international codes and guidelines of good corporate governance practices. This is represented by a Corporate Governance Score (CGS) on a scale from 1 (lowest) to 10 (highest). We analyse four key components of governance: ownership structure, financial stakeholder relations, financial transparency and information disclosure standards and board structure and process.
Investors and other interested parties can use the scores as part of a risk assessment process. Companies may choose to go through the scoring process on a confidential basis, or to use their scores publicly.
Amra Balic is associate director, Standard & Poor's Corporate Governance Services, E-mail: Amra_Balic@standardandpoors.com
OECD ROUND TABLE
Last year, the OECD, working with the World Bank Group and other partners, launched a roundtable consultation on corporate governance in South East Europe. It involved policy makers, regulators, investors and business and labour representatives. The goal is to make specific recommendations on ways to improve corporate governance in the region.
More than 100 participants from 18 countries, including Albania, Bosnia and Herzogovina, Bulgaria, Croatia, the Former Yugoslav Republic of Macedonia, Romania and Yugoslavia attended the inaugural session. After further meetings, the consultative group hopes to produce a white paper containing detailed proposals for action. The first meeting focused on shareholder rights and related issues. Future meetings will deal with issues of transparency and disclosure, company boards and the role of directors and the rights of other stakeholders.
The OECD has been leading efforts to improve corporate governance worldwide since 1999, when its member countries adopted the OECD Principles of Corporate Governance.
The First International Conference on Corporate Governance: 'Corporate Governance Developments and the New Tools of Governance' will mark the official launch of the Centre for Corporate Governance Research at the Birmingham Business School, University of Birmingham, on 9 July. Sir Adrian Cadbury will be attending the event as the Centre's external adviser.
Papers have been invited on issues relating to any area of corporate governance. Possible topics are: boards of directors, executive remuneration, corporate governance ratings systems, internet and corporate governance, electronic voting, institutional investors, and developments in corporate governance codes.
Evaluating Emerging Markets
Following a report by its pension consultant Wilshire Associates, CalPERS has established a new framework for evaluating emerging market countries. This gives a 50% weighting for country factors and a 50% weighting for market factors. There are eight broad categories of factors (macro-factors) that CalPERS uses to evaluate the risks of each emerging market country and its equity market.
Country factors pertain to the specific country as opposed to its capital markets. Without strong country infrastructures to support the capital markets, the markets cannot truly be viable. Market factors are the market specific risks that determine whether the markets, themselves, can support institutional investment. CalPERS says that, collectively, these factors are designed to evaluate the investability of these markets for institutional investors. In view of the pace of development in these markets, it will carry out this analysis at least every year.
Country factors are:
Market factors are: