DEBATE: Should corporate governance ratings be banned?

Madhav Mehra (left), and P K Choudhury

Madhav Mehra
President, World Council for Corporate Governance

An interesting debate is ensuing in India on the importance of corporate governance ratings, which can be of great relevance for the international investor community.

G N Bajpai, chairman of the Stock Exchange Board of India is bullish on corporate governance ratings. Two rating organisations in India "" ICRA and Crisil "" have developed well-thought-out criteria for measuring corporate governance practices and value creation for all stakeholders. These take into account ratings on wealth creation, wealth management and wealth sharing, and are based not only on data published in the public domain, but also detailed interviews with management and stakeholders.

Recently, M Damodaran "" accredited with the turnaround of the Unit Trust of India "" has criticised the idea of corporate governance rating and asked for a ban on the ratings by credit-rating agencies until companies implement corporate governance more in content rather than as a check list compliance merely to satisfy the stock market.

If there is one lesson that can be learnt from the corporate scandals at Enron, Worldcom, Global Crossing, Marconi, Equitable Life, Parmalat, Skandia, Vivendi and now Shell, it is to move away from the box-ticking approach to corporate governance. Enron had ticked every box. More than 50 per cent of its directors were independent. The chairman of its audit committee was a person of irreproachable reputation as Dean of Stanford Business School.

It was declared "the most innovative company" by Fortune for five successive years. McKinsey was consultant to Enron and collected fees of $ 10 million a year. It had top ratings from every rating agency until days before filing for chapter 11. The story repeats itself verbatim in almost all the subsequent investigations.

Lynn Turner, chief accountant of SEC from 1998-2001, who was earlier a partner of Cooper & Lybrand, admitted in a TV interview, "All Big Five accounting firms helped Wall Street investment banking firms to engineer hypothetical transactions to make companies look better than they actually were."

There is a further danger in the Indian scenario. Unlike the UK, India is still grappling with reform on the appointment of independent directors. A report submitted by Naresh Chandra Committee has been scuttled.

The report that recommended at least 50 per cent directors to be independent, created the same storm as in the UK, but India did not have Patricia Hewitt to stem the revolt. The government has capitulated to these corporations and the report is collecting dust. Independent directors are the cornerstone of good corporate governance.

The current rating systems are based on the results available in the public domain. There is no system of checking the veracity of the claims. To be meaningful, ratings have to address the process and not the result. This is difficult to measure when we do not even have well-defined criteria to measure them.

Besides, wealth creation, as measured by the market capitalisation, may be due to market effect and have nothing to do with corporate governance practices. A case in point is the profits generated by steel companies worldwide because of unusually high demand by China.

Another example is that of Antofagasta, a Chilean company that outperformed the market by 58 per cent over the past year on the back of rising copper prices.

On the other hand, BHP Billiton, the London-listed Australian-African mining group believed to be following best practices in corporate governance, has outperformed only by 24 per cent.

The real issues that determine the quality of corporate governance are the issues of heart. No law, rule or rating can be an effective measure. It is naïve to think that the ratings can truly measure transparency, equity, accountability, integrity and responsibility "" the five pillars of good corporate governance.

Stock markets work on a short-term basis. Every CEO is in the mortal fear of quarterly results and lives from quarter to quarter. We have to educate investors that in an economy based on innovation there is no way companies can give a double-digit growth every quarter, unless CEOs manage expectations and resort to earning manipulation. Markets have to learn to reward good tries and not just successes, which may simply be flukes.

There is no doubt that the effort to popularise corporate governance rating has good intentions, but these intentions will be better served by directing all efforts on strengthening the fundamentals of corporate governance in India by getting the two important reports "" Narayana Murthy's and Naresh Chandra committee's "" implemented. Corporate governance ratings until then can be counter-productive.

P K Choudhury
Managing Director,
ICRA Limited

The rationale for the proposition is possibly that corporate governance rating does not have any utility so far as stakeholders are concerned. Corporate governance rating and, for that matter, any rating is an opinion by an independent professional agency. The opinion is backed by adequate research and due diligence process carried out by competent professionals with appropriate skills, and reflects a dispassionate view.

Corporate governance rating is one such opinion, about the level of corporate governance (practiced by an entity). It takes into consideration aspects like ownership structure, management style, including board-level issues, quality of financial reporting and disclosure practices, and sensitivity to the interests of different financial stakeholders. I firmly believe that all the stakeholders should have the right to obtain the benefit of an independent opinion on all the specific areas.

There were quite a few surveys carried out, including a recent one by ICRA, that enable a definite conclusion that equity investors, in particular, may derive enough comfort in their decision-making process from such opinion on the corporate governance of an entity in which they are investing.

The question is, why should these investors be deprived of this opinion? Corporate governance rating is gaining popularity not just with stakeholders; even regulators in many countries have taken cognisance of its utility and are working out how to make best use of such a rating to facilitate healthy development of capital market.

Several committees have deliberated on corporate governance and have come up with certain recommendations. But, face it, mere compliance with statutory and regulatory requirements is not good enough.

Rather, it is expected that such compliances would be there for almost all the entities, at least, in letters, if not in spirits. This does not necessarily mean that all such entities would have excellent corporate governance standards. There will be differences and the opinion of a rating agency would reflect such differences and stakeholders would derive different levels of comforts in dealing with each of such corporations.

There are corporations that follow excellent corporate governance standards, which they need to communicate to the outside world. However, such claims by a corporate entity, on its own, may not always be credible and needs to be supported by verification by an independent body such as a credit-rating agency.

The regulators in many countries are conceptually supportive of this endeavour of the rating agencies. First, if entities with high levels of corporate governance standards get themselves rated and announce such ratings, this may encourage those with relatively lower corporate governance standards also to improve and get themselves rated. This in turn, will result in an overall improvement in the corporate governance standards within the country.

Credit-rating agencies while assessing any rating make a comprehensive disclosure of the rationale behind such rating and also identify the deficiencies. This will enable an entity to improve on its level of governance by taking corrective measures. Rating agencies will carry out not only a rating, but also monitoring of such ratings, which will discourage deterioration in the standard of corporate governance. This will be of great benefit to the different groups of financial stakeholders.

Let us first decide whether the different stakeholders of a corporate entity need an opinion on its level of corporate governance standard. The different studies carried out so far reaffirm that such opinions could be of great help.

If that is true, then the options left to a stakeholder are:

• To rely on the claim made by the corporate entity about its level of corporate governance.
• Carry out its own investigation to form an opinion.
• To rely on own biased opinion of an independent agency for the required level of competency and carry out appropriate due diligence through a structured process.

A stakeholder may not be comfortable with the first option. Rather, he would prefer the second option. The problem with the second option is that he may not have the required skill or time available to carry out a detailed exercise to arrive at a judgement in this regard. Even if he has skill and time available, it may not be possible for the corporate entity to provide access to all sensitive documents to all the stakeholders, since this would be unmanageable.

A better option for the stakeholder would be to rely on an entity that would be prepared to deploy adequate resources to carry out the exercise, arrive at the judgement after a thorough analysis of all the objective and subjective issues through a process of collective consultation.