DEVELOPING A MEASURE OF THE QUALITY OF CORPORATE GOVERNANCE

Dr. Anurag Pahuja

E-mail: [email protected]
Faculty-Finance, Apeejay Institute of Management,Rama Mandi-Hoshiarpur Road, Jalandhar,
Punjab (India)
Editor, Apeejay Journal of Management & Technology

ABSTRACT

This conceptual paper provides an overview of various constituents of good quality of corporate
governance. Despite many researchers advocating good governance for ensuring good health of
business organizations, a consensus on what constitutes good corporate governance has not
been arrived at. This article attempts to bring together various constituents known to affect the
quality of corporate governance individually and provides a summary measure known as
Corporate Governance Quality Index (CGQI).

Keywords: Corporate governance, Corporate governance quality, Board Independence,

Transparency, Shareholders‟ rights

1. INTRODUCTION

The concept of corporate governance has succeeded in attracting a good deal of public interest
because of its apparent importance for the financial health of the corporations. Corporations pool
capital from a large investor base both in the domestic and in the international capital markets. In
this context, investment is ultimately an act of the faith in the ability of a corporation‟s
management. When an investor invests money in a corporation, he expects the board and the
management to act as trustees and ensure the safety of the capital and also earn a rate of return
that is higher than the cost of capital. Corporate governance deals with the ways in which
suppliers of finance to corporations assure themselves of getting a return on their investments
(Shleifer & Vishny, 1997). Joint stock companies share many of their features with
democratically elected governments. Both command enormous economic resources and enjoy
the mandate of their electorates to use these resources for greater benefit of all. Corporate
governance is the system by which business corporations are directed and controlled (Cadbury,
1992). Board of directors in the company, being entrusted with responsibility to run the corporate

Electronic copy available at: http://ssrn.com/abstract=2622960

are central in the system. The directors are responsible and accountable to various stakeholders,
specifically, the shareholders. The corporate governance is a system of making directors
accountable to the shareholders for effective management of the corporation with an adequate
concern for ethics and values.

Corporate governance, as a process, involves two dimensions which are the responsibility of the
board (or governing body) i.e. performance and conformance to the standards established by the
authorities. There are some commonly accepted key principles or elements of good governance
that are applicable to both the public and private sectors. The three most common are:
accountability – both internal and external; transparency/openness; and recognition of
stakeholder/shareholder rights. Efficiency, integrity, stewardship, leadership, emphasis on
performance as well as compliance, and stakeholder participation are the most often added
attributes to reflect better corporate governance. Corporate governance is one of the critical
issues in business today. It is universally accepted that good corporate governance is the most
required virtue for the success and reputation of any organization. According to Bain and Band
(1996), good corporate governance is an essential element for any organization that intends to
maximize its effectiveness. Good governance means securing access to broader-based, cheaper
capital for companies. For investors, a commitment to good governance means enhanced
shareholder value. For both, good governance means good business.

Despite the well recognized importance of good corporate governance to organizations, there is
no measure of corporate governance, which is acceptable worldwide. Many of the empirical
studies have proved that there is a widespread consensus that good corporate governance
practices increase shareholder value. But how to measure the quality of corporate governance is
still under debate (Bebchuk, Cohen & Ferrell, 2004).

Various researchers and organizations have identified different elements that describe good
corporate governance. Based on OECD principles of corporate governance, Campos, Newell and
Wilson (2002) in their study have emphasized 15 elements of good corporate governance like
dispersed and transparent ownership, meeting notification, board size, independent directors,
written board guidelines, board committees and timely disclosures, to name a few. Despite
various attempts to define corporate governance and its elements, and suggested models of good

Electronic copy available at: http://ssrn.com/abstract=2622960

corporate governance, no universally accepted model of good corporate governance exists
(Choraria, 2006; Marisetty & Vedpuriswar, 2005).

2. OBJECTIVES AND METHODOLOGY OF THE STUDY

This study constitutes a new step in corporate governance research because it proposes a precise
measure of the quality of corporate governance that is useful to predict firm value in Indian
context. The approach followed consists of constructing an index of corporate governance
quality based on all existing governance provisions as applicable under SEBI guidelines in the
form of Clause 49 of listing agreement and the best practices as identified after the review of
studies conducted in India and abroad and the corporate governance rating methodologies
adopted by various credit rating agencies i.e. CRISIL, CARE and ICRA etc. The methodology
followed by the Institute of Company Secretaries of India for assessing corporate governance has
been considered to a great extent. Corporate governance is about commitment to values and
ethical business conduct. Good corporate governance is reflected in fair, transparent and
responsible interactions between a company‟s management, its board of directors, shareholders
and other stakeholders (CRISIL, 2008).

3. DETERMINANTS OF QUALITY OF CORPORATE GOVERNANCE

Recent developments in India and around the world have drawn the attention of market
participants on the need to improve corporate governance. Evidence suggests that companies that
do not follow meaningful governance practices are required to pay a significant risk premium
when competing for raising capital in public markets. With investors and other stakeholders
becoming more and more astute and demanding in the wake of certain major corporate collapses,
it has become maneuver to ensure good governance. While legislation can lay down the ''form''
to ensure standards, the ''substance'' will ultimately determine the credibility and integrity of the
process (CARE, 2008). Standard & Poor's global equity research departments assess the quality
of corporate governance based on three broad categories. These include board of directors'
organizational structure, executive compensation and shareholder rights (Burba, 2005). The
Corporate Governance Quality (CGQ) index as developed by De Nicolo, Laeven and Ueda
(2006) does not capture all aspects of corporate governance but focuses only on two important
aspects of corporate governance i.e. disclosure and transparency only.
In this paper, for the ease of understanding, determinants of quality of corporate governance have
been put into five categories namely (1) transparency and disclosure compliances, (2)
shareholders‟ rights and relationships, (3) board composition, independence and governance, (4)
functioning of board and board committees, and (5) stakeholder value enhancement and
corporate social responsibility/other corporate governance initiatives. A corporate governance
quality index is developed based on these categories given below.

3.1 Transparency and Disclosures

Transparency means timely disclosure of adequate information on the company‟s operating and
financial performance and its corporate governance practices. This helps stakeholders to monitor
the operation and performance of the management. Transparency is assumed to improve markets
efficiency, to enhance better corporate governance and finally, to ensure moralization of business
life (Bessire, 2005). Openness and timely disclosure of adequate information on corporate
financial performance is considered the best means to make corporate more accountable to their
stakeholders. Frequent and credible disclosure in a transparent manner is a reflection of the better
quality of a company‟s corporate governance practices. A company should offer multiple
channels of access to its information, including both on-line and off-line access. Information
should be in both local language and English (Campos et al., 2002). At a minimum, a company
should provide disclosure on financial and operating performance; business operations and
competitive position; corporate charter, bylaws, and corporate mission; and board members
backgrounds and the basis of their remuneration. This study tends to evaluate the quality of
disclosures and transparency of an entity based on the following parameters: compliance with
accepted accounting standards; consistent application of accounting policies and changes, if any,
in these policies; quality of information under „Management Discussion and Analysis‟;
disclosures regarding investment in companies under the same management; related party
transactions; the information on financial performance provided at company‟s website and
Electronic Data Information Filing and Retrieval (EDIFAR) system and all the items as
mentioned in the suggested list of items to be included in the report of corporate governance in
the annual report of companies as per the revised Clause 49. Information should be disclosed in a
timely manner based on standards of the listing stock exchange.
Transparency and disclosures are necessary, albeit not sufficient, conditions of good corporate
governance, since the extent of information asymmetries among managers and stakeholders
pointed out by the corporate governance literature are likely to be less severe with enhanced
transparency and disclosures (Becht, Bolton & Rosell, 2003; Berglof & Claessens, 2006; Shleifer
& Vishny, 1997; Tirole, 2001 & 2006; Zingales, 1998). Apart from transparency, protection of
shareholders‟ rights and maintaining good relationships with them is another contributor to good
quality of corporate governance.

3.2 Shareholders’ Rights and Relationships

The typical corporate governance framework views shareholders as the principal, and the
objective of the management of a corporation is to maximize the interests of the shareholders.
Shareholders being owners of the company by virtue of having put in their stake in the business
are entitled to have their say in management of the company. As per the statute, they are
empowered to elect the board members, auditors, and vote in major decisions of the company
such as mergers, amalgamation, etc. and are entitled to receive dividends. Even though
shareholders entrust the board of directors to guide and monitor the management, they are given
rights and opportunities to participate directly in monitoring their firms (Nam & Nam, 2005).
Their basic rights include: the right to have their shares transferred and registered smoothly; the
right to access timely information; the right to participate in, and vote at, shareholders‟ meetings;
the right to elect members on the board; and the right to share the organization‟s profits through
dividends. Also, an organization must have appropriate systems in place to enable its
shareholders participate effectively in shareholders‟ meetings and cast their votes. Besides, an
organization has the duty of keeping its shareholders informed of the rules and voting procedures
that govern general shareholders‟ meetings. In a properly governed company, taking due care of
shareholders‟ rights and maintaining good relations with them play a very important role. This
study basically examines what a company does in articulating and protecting shareholder rights
that is to what extent it is complying with the law, the ease and effectiveness of shareholder
participation at meetings and where its practices go beyond laws and regulations to address the
spirit of governance. The emphasis is on what a company does, rather than its compliance with
the minimum required by the law (CRISIL, 2008a).
This study evaluates the following aspects for ascertaining whether the shareholders are treated
equitably: procedure for holding Annual General Meeting (AGM) like place and time of
meeting; dispatch of notice and other related papers to shareholders; handling of requests for
registration of share transfer; response to the queries of shareholders; quality of handling
shareholders‟ grievances; adequacy of information given to shareholders; and dispatch of
voluntary information to shareholders (CARE, 2006). Shareholders should be notified at least 28
days prior to each general shareholder meeting to allow overseas investors to participate, and
online participation should be available for shareholders.

3.3 Board Composition, Independence and Governance

Efficient and effective governance is essential for accomplishing the goals of organizations. The
board of directors, being in charge of the day-to-day business and management of the
corporation, plays a pivotal role in ensuring good governance (Athavale, 2004). Board provides
the strategy, policies and guidelines to an entity for its orderly functioning and growth. An
effective board is the key to success and corporate discipline. Board is appointed by the
shareholders who invest in the capital of the company and board appoints certain key
functionaries of the company for the management of its affairs. It thus works as a link between
shareholders and executive management. Board appoints, directs and reviews the management of
the company and is accountable to its shareholders. It is also responsible for compliance with
statutory requirements and protection of rights of shareholders. Board should comprise of
professionally acclaimed non-executive directors who, while overseeing the management, can
also discharge their fiduciary duties towards shareholders and other stakeholders. The non-
executive directors or independent directors are assumed to monitor the actions of management
and ensure that management decisions are made in the best interests of the stockholders (Petra,
2005). An independent director should not only find himself formally in the right position, but
have the ability and willingness to make an independent judgment (Van Den Berghe & Baelden,
2005).

The study looks at the composition of the board and its various sub-committees. Boards should
be structured in such a way that the interests of all the shareholders and stakeholders are
respected, represented and protected. It evaluates whether the board contains a good balance of
independent and executive directors, and whether the board has the right mix of various
capabilities required for governing the company, taking into account the size, industry nature and
growth objectives. The board should be neither too big nor too small. Empirical analysis suggests
that the optimal board size is from five to nine members.

As per the Clause 49 of listing agreement, no more than half of the directors should be
executives of the company. Stated differently, at least, fifty percent of the board should comprise
of non- executive directors. At least half of the non-executive directors should be independent
outsiders if chairman of the board is an executive chairman. In case the chairman is a non-
executive director, at least one-third of the board should comprise of independent directors.

It also includes other aspects like selection process for board members, succession policies for
board members, processes for ensuring availability of relevant competencies on the board, and
board compensation.

3.4 Functioning of Board and Board Committees

One of the major components of corporate governance is board of directors and the committees
constituted to manage the affairs of the business. Board is authorized to form committees for
specific purposes by nominating a few directors and vesting with them specific powers and
responsibilities. The board of a company should also appoint independent committees to carry
out critical functions such as auditing and internal controls; top management compensation; and
to look after the interests of shareholders. In this regard, at least an independent audit committee,
remuneration committee and shareholder grievance committee should be constituted in the
organization. There can be other committees also to handle the organization specific functions
(Campos et al., 2002) like nomination committee and investment committee. The methodology
used in the study evaluates the functioning of the board and its committees in the light of
statutory requirements as also the suggestions/recommendations made by different professional
organizations and assesses the board‟s role in providing independent oversight of management
performance. Though Clause 49 of the listing agreement does not make it mandatory for a
company to set up other board-level committees like the remuneration committee and the
nomination committee yet it is believed that issues like established and transparent criteria for
selecting independent directors, determining directors‟ remuneration, and ensuring that directors‟
and senior management's remuneration is aligned with the company‟s performance are important
indicators of a company‟s corporate governance quality. A company should have its own written
corporate governance rules that clearly describe its vision, value system, and board
responsibilities. Based on the rules, directors and executives should be fairly remunerated and
motivated to ensure the success of the company. The information regarding the following
committees has been collected.

3.4.1 Audit Committee

An audit committee is a mandatory internal control mechanism required in all listed firms to
ensure effective enforcement of good corporate governance. The composition of the audit
committee is an important issue since all its members need to have adequate experience in the
areas of finance and accounts (ICRA, 2004). The audit committee, comprising of a substantial
majority of independent directors (at least two-third as per Clause 49) who also have finance and
accounting expertise, is expected to play a very important role in ensuring proper disclosure and
transparency as regards to financial performance, financial discipline and functioning of the
company. It has the powers to appoint or remove the auditor. It is empowered to evaluate internal
control mechanisms with external and internal auditors. Responsibilities of an audit committee
are to review the internal audit reports and the results of the audit, selection and appointment of
external auditors, and review the internal accounting controls and safeguarding of corporate
assets (Petra, 2005). Following parameters have been evaluated in case of audit committee:
composition of the audit committee; independence of the audit committee; qualifications and
experience of the members; number of meetings in a year; and adequacy and quality of
information.

3.4.2 Shareholders/Investors Grievances Committee

The shareholder grievance committee helps in proper handling of shareholders complaints, more
particularly, of minority shareholders. The primary role of shareholders‟ grievance committee is
to address the investors‟ grievances promptly and satisfactorily including redressal of investors‟
grievances pertaining to transfer/ transmission of shares, dividends, dematerialization,
replacement of lost/stolen/ mutilated share certificates, splitting conversion and other related
issues and to strengthen investor relations (Zahir & Sisodia, 2006). All the listed companies are
required to provide the details regarding the number of complaints received during the year,
number of pending complaints, and the process of handling of shareholders complaints etc.
3.4.3 Remuneration Committee

Also sometimes referred as compensation committee, the remuneration committee is authorized

to determine on the behalf of the board and shareholders, the company‟s policy on specific
remuneration packages for executive directors. Michael and Gross (2004) raise their concerns
regarding the astronomically high compensation being given to the top executives. There have
been instances where multi-million bonuses paid to the founders were hidden from public
scrutiny by questionable accounting practices. Grant (2003) points out that ironically those
CEO‟s at firms where management problems are greater often receive higher financial rewards
even though such companies are typically poorer performers. Therefore, it becomes important
that an independent compensation committee is set up which could strengthen corporate boards
by controlling the level of CEO compensation. It is expected to fix remuneration in such a
manner that it provides an incentive system to align the interests of management with that of the
shareholders and other stakeholders (Narsimhan & Jaiswall, 2007). This study evaluates the
following parameters in case of remuneration committee: composition of the remuneration
committee; independence of the committee; adequacy of information furnished; access to the
remuneration committee; and transparency in fixing the remuneration/compensation for various
categories of directors. In case of companies where, remuneration committee is not formed, the
process/parameters for fixing the remuneration of the directors is/are looked into.

3.4.4 Nomination Committee

The nomination committee, composed entirely of independent directors, plays an important role
in search for new directors and making the process followed for appointment of directors very
transparent and how the directors are identified for induction. The committee screens the
prospective candidates for the position of non executive directors and selects them finally
(Balakrishnan, 2006).

3.4.5 Investment Committee

Investment committee is expected to supervise investments made by the company as per

directions of the board. The constitution of this committee has gained more substance in recent
times as a number of companies are putting their funds in stock market operations. It is not a
mandatory requirement to have this committee; still it is considered a good practice to constitute
investment committee.

3.5 Stakeholder Value Enhancement and Corporate Social Responsibility/Other Corporate

Governance Initiatives

Corporate Social Responsibility (CSR) involves changing notions of human welfare and
emphasizing a concern about the social dimensions of business activity that have a direct bearing
on quality of life in the society (Sharma & Talwar, 2005). They quote Infosys Chairman,
Narayana Murthy, who proposes, “social responsibility is to create maximum shareholders value
working under the circumstances where it is fair to all its stakeholders, workers, consumers, the
community, government and the environment”. The strength of a company‟s relationship with all
its stakeholders (including shareholders) is an important determinant of better quality of
corporate governance. Every stakeholder group has a distinct expectation from the corporate
body. It is for the corporate house to balance the needs of various stakeholders and to distribute
the limited resources, at its disposal, amongst all stakeholders in the most equitable manner
(Dhanjal, 2006).

CRISIL has devised parameters to quantify the delivery of value to each stakeholder (CRISIL,
2008a). The key parameters that CRISIL considers while analyzing the value delivered to
various categories of stakeholders have been used in this study too. The information related to
the measures taken by the organization to enhance value of various stakeholders like employees,
customers, vendors, bankers and society at large has been identified in this section.

3.5.1 Employees

Value is created for employees in the form of wages and salaries, bonuses, stock options, pension
and other tangible and intangible benefits. Policies on job rotation, promotion, transfer, training,
career growth etc. help in motivating employees and creating a sense of belongingness to the
company. A firm that improves these benefits creates additional value for the employees. The
ability of the company to provide these benefits regularly is what is of prime importance for
employees.

3.5.2 Lenders/creditors
Lenders provide the debt finance to leverage capital of an entity. The track record of the entity in
servicing debt and movement of credit rating over a period of time is important indicator of the
capability of the entity to service its debt obligations. Enhancement or even maintenance of the
debt paying capacity creates value for lenders/creditors. Creditors consider consistent debt
paying capability of the borrowers an important factor in deciding about their lending decision.

3.5.3 Suppliers

Suppliers share an interdependent relationship with a company and have a stake in the well being
of the firm for continued business and steady source of revenue. Fair treatment to suppliers helps
in building long term relationship that is mutually beneficial to both parties. Timely payment to
suppliers and other tangible and intangible benefits through vendor development policies etc.
provide inputs to an entity‟s value creation capability to suppliers.

3.5.4 Customers

Providing better quality products and services as compared to competitors, at reasonable prices
makes customers loyal to the organization. Satisfying the expectations of the customers and
measures taken to retain them ensure long term success of the organization. Assessing customer
grievance redressal policies of the firm, quality of product and services delivered and surveys to
know customer satisfaction level forms a part of this study.

3.5.5 Society

For reciprocating the inputs and other resources which organizations get from society at large,
they too have an obligation towards welfare of the society. Direct as well as indirect measures by
which a company contributes towards social infrastructure, welfare measures, environment
protection and local community development have been used to assess value creation capability
of the firm for society.

It is clear from the above discussion that the scope of corporate governance is much wider than
merely corporate management and includes all the major parameters of accountability, control,
transparency and reporting system. It also encompasses the interactive relationships among
various constituents in determining directions and performances of business organization. It is a
system of structuring, operating and controlling a company with a view to achieve long-term
objectives to satisfy shareholders, creditors, employees, customers and suppliers with the legal
and regulatory requirements, apart from meeting environmental and social obligations.

As already indicated, various researchers on corporate governance, credit rating agencies and
other organizations like Standard and Poor (S&P) have their own ways of measuring quality of
corporate governance. This study uses a composite measure of the quality of corporate
governance i.e. CGQI, which reflects all the best practices as suggested by the regulatory
mechanism in India and abroad, related to transparency and disclosures; shareholders; board
composition, independence and functioning; and social responsibility towards various
stakeholders etc. For developing the index, the questionnaire consisting of above mentioned five
sections was administered to the company secretaries, wherein each question within a section
carries a score of 10 at the maximum. Where there are a number of items in a question, the
maximum score obtainable is distributed amongst them. The score obtained in each section is
summed up and then the weightage factor is applied for that section to calculate the score earned
by the company in that particular section. In the process, as there are five sections, equal weights
are assigned to each section i.e. 20 percent each to avoid any subjective judgment of the relative
weight assigned to any section. The weighted scores obtained in each section are the scores for
the sub-index ranging between 0-20. Next, scores from sub-indices are compiled into overall
corporate governance quality index. Each sub-index is calculated as the weighted average score
of its contained questions and a Corporate Governance Quality Index (CGQI) is calculated for
each company as the sum total of five sub-indices. Therefore, the CGQI ranges from 0 to 100,
with better-governed firms having higher index scores.

It is obvious from the whole discussion that better quality of corporate governance is reflected in
protecting and maintaining a balance between the interests of stakeholders by setting up the
appropriate mechanisms (as discussed under five categories) to align these conflicting interests
and to ensure monitoring of management. This is basically done with the help of vigilant board
of directors with enough independence who can voice against the misconduct of management
and adequate and transparent disclosures of the processes and functioning of the organization
through annual reports.
To conclude, it can be said that good corporate governance is a shared way of corporate
functioning and not just a set of rules. The corporate actions need to confirm to letter and spirit in
which the society and authorities allow corporate to function.

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