Good performing firms have better corporate governance

By Priya Chetty on July 2, 2015

Corporate governance refers to the administration of corporations. One of the broadest definitions of the term was used by Sir Adrian Cadbury, head of the Committee on the Financial Aspects of Corporate Governance in the United Kingdom: “Corporate governance is the system by which companies are directed and controlled”(Cadbury Committee, 1992). The world economy has been facing a series of crises: in Russia, Asia and Brazil in 1998, Europe and US in 2002 and more lately the 2008 global economic meltdown. The common denominator of all these crises is weak corporate governance systems. With the separation of ownership and management of capital has become an irreversible feature of business. Maintaining high standards of corporate governance has become very important to ensure that the interests of all the stakeholders, shareholders, employees, creditors, government, consumers etc. are taken care of. Recently, corporate social responsibility, that is, aspects pertaining to culture and environment have also been included within the ambit of corporate governance (Claessens & Yurtoglu 2012).

Corporate governance practices in emerging economies

According to the International Monetary Fund, emerging economies account for nearly 40 per cent of the world GDP. Given their high growth prospects, they are an attractive destination for many investors. However, investors face multi-faceted risks both at the country and the company level (George Dallas, F&C Management Ltd. for The Harvard Law School Forum on Corporate Governance and Financial Regulation 24 August 2011).

Of the various tools available to regulators to promote better corporate governance is a disclosure. When companies put information in the hands of the markets, investors can make better informed decisions; they will know the extent to which the company responds to shareholders’ needs, risks and the quality of future cash flows. “Guidance on Good Practices in Corporate Governance Disclosure”, published in 2006 by The United Nations Conference on Trade and Development (UNCTAD) provides a benchmark of more than 50 corporate disclosure items. Since it was developed by UNCTAD’s Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR), it is also called the UNCTAD ISAR benchmark.

The UNCTAD in 2011 published a report on corporate governance disclosure in emerging markets. The report integrated and compared four years of UNCTAD’s cross-country data on the issue. The report reveals that most of the 25 emerging markets analyzed made considerable use of mandatory disclosure: 18 countries (nearly three quarters of the sample) require disclosure of two thirds or more of the 52 items in the UNCTAD ISAR benchmark. While Ownership Structure, Exercise of Control Rights and Financial Transparency were the most commonly items subjected to national mandatory disclosure. Board and Management Structure and Process revealed great variations with respect to number of items to be disclosed. Corporate Responsibility and Compliance has lower frequency of mandatory disclosure given the novelty of the concept. However, given its crucial role in corporate governance, the fact that Auditing does not come under mandatory disclosure for many countries is surprising.

Thus, the report finds that disclosure requirements in emerging markets are quite strong. However, in some cases they are fewer than required. Moreover, gaps with respect to auditing and compliance also need to be addressed (Corporate Governance Disclosure in Emerging Markets, UNCTAD Report, 2011).

Corporate governance and a firm’s performance

Among the factors that affect corporate governance in emerging economies would be:

  • The quality of public governance.
  • The incentives and the quality of government officials and the regulators, product market competition, financial market development and ownership structures.

Firstly, in a country with high corruption levels, corporate governance and transparency is bound to be sub-standard. In such a scenario, a company which resorts to higher compliance and does not tolerate bribery will face higher operating costs and will be at a competitive disadvantage.

Secondly, the incentives and the quality of government officials and the regulators play an important part where state ownership is common and that in turn determines corporate behavior. For example, state ownership yields positive results in China (Prof. Acharya in Global Corporate Governance Forum 2013).

Thirdly, product market competition which is generally considered to have a positive impact on corporate behavior is generally not perfect in emerging economies. The imperfections are more pronounced in case of protected sectors.

The motivation for the emergence of business groups vary from one of tax avoidance to reduction of transaction costs to diversifying risks. Depending on the motive, these business groups have shown varied performance levels. Whereas they are highly successful in India but they are not so successful in Columbia. Moreover, the regulations regarding these business structures and enforcement of the same also contribute to their success or otherwise. For example, in India, a company can hold as many subsidiaries as it likes.

Finally, ownership structures vary widely in emerging economies with varying effects. In countries like Thailand where families are tightly knit, the presence of family members on the Board and managerial positions enhance performance while in countries like the Republic of Korea, the presence of outsiders on the Board has a more positive influence (George Dallas, F&C Management Ltd. for The Harvard Law School Forum on Corporate Governance and Financial Regulation 24 August 2011).

 Corporate governance in capital market

The development of capital markets in emerging economies will depend greatly on two factors:

  1. The ease with which a company is able to raise finance.
  2. And the company’s financial performance.

These two factors in turn depend on the corporate governance standards adopted by the companies. A company which complies with all the disclosure norms enhances confidence in investors regarding the returns they can expect (Brown et al. 2004). Thus, the cost of equity for such companies goes down. Another factor which might influence the decision of shareholders is the pattern of financing. In case of high ownership presence (families and banks owning huge proportion of the share), the rights of minority shareholders may be expropriated. Hence, the latter may hesitate to invest in such companies which are then forced to go in for debt financing. This results in risky capital structure (e.g. higher leverage) for the company. Moreover, better corporate governance will mean better allocation of resources, optimum utilisation of assets and more effective management which in turn will greatly enhance the firm’s financial performance.

If companies are not controlled by small groups of dominating shareholders and resort to good corporate governance practices, they are more successful in raising equity capital at lower rates. This in turn leads to the development of robust capital markets. Conversely, poor corporate governance will have adverse effects on a robust capital market (Haque et al. 2003).

Emergence of corporate governance

Corporate governance encompasses a wide spectrum of a firm’s governance components. This term became a household name post the Enron corporate scandals and the passing of the 2002 Sarbanes Oxley Act by the US (Corporate Governance Disclosure in Emerging Markets, UNCTAD Report, 2011). Emerging economies of the world vary greatly in their corporate practices due to their varied economic and financial infrastructure. The UNCTAD report finds that there is a clear need to improve disclosures and sometimes make them mandatory in order to improve reporting regime and help companies improve their communication with shareholders and other stakeholders. Corporate governance improves a firm’s financial performance and enables it to raise cheap equity. This in turn helps develop capital markets in emerging economies. Hence, governments in emerging economies will do well to increase awareness and enforce high standards of corporate governance practices.