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Any discussion of corporate governance is complicated by the lack of a universally accepted

definition of the term. Most experts and commentators agree that governance is about the
management of a company and the extent to which stakeholders' interests are respected and
protected. However, there is often disagreement over exactly who are the stakeholders. In the
Anglo-American market model (liquid stock markets and widely dispersed shareholders), governance
often focuses on the interests of financial stakeholders, primarily shareholders. In the continental
European market model (less liquid stock markets and cross shareholdings between industrial
groups and banks), governance is often extended to a broader range of stakeholders, including
employees and customers. This article makes no attempt to judge either system. In fact, some
experts predict that the globalization of business and markets will lead to a convergence of the
various governance models.

Why has governance become increasingly important? It is perhaps useful to look to history for a clue
to the answer. Before the early part of the 20th century, companies were typically owned and
managed by the same group of people. As companies grew, the need for external finance resulted in
an increased number of owners (shareholders) and a need for professional managers to manage the
business on behalf of the increased number of shareholders, who individually had little influence
over the company's management and the day-to-day running of the business. This development
brought a new problem Ͷ the so-called agency problem Ͷ where the interests of the company's
managers (its agents) and its shareholders were not always consistent. This is the governance
problem Ͷ the problem of ensuring that a company is managed, directed and controlled in the
interests of all its stakeholders.

Effective corporate governance is 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, through both internal governance procedures and external legal and regulatory
mechanisms, in order to ensure that a company's assets are being used in the interests of all
financial stakeholders. This is key in both developed and developing economies.

In developed markets, large institutional investors pay considerable attention to corporate

governance practices. Some US pension funds, such as CalPERS and TIAA/CREFF, actively pursue
corporate reform through positions as big shareholders. Every year, for example, CalPERS publishes
a list of the best and worst US corporate boards in an attempt to promote change. As institutional
investors own more than 50% of the equity of US companies, companies are becoming much more
sensitive to the desires of these shareholders.

The market rewards companies that change. Some studies have shown that efforts by a company to
improve the quality of its board have a significant and positive effect on share price. Similarly,
companies that continue to engage in activities that place the interests of management over those
of shareholders tend to trade at a discount relative to other companies in their sector.

In emerging economies, the quality of corporate governance can vary enormously. Indeed, poor
governance or corrupt governance (crony capitalism) negatively affects the returns on investment in
many countries and also contributes to larger, systemic problems at national and regional levels. The
scarcity and poor quality of publicly available information, as well as limited legal and regulatory
recourse, frequently complicate efforts by financial stakeholders to ensure that management is
acting in their interests.

The expropriation of outside investors (sometimes done legally) is a big problem in corporate
governance. Although expropriation is not exclusive to emerging economies, it is certainly much
more prevalent there. Examples of expropriation include cashflow diversion (transfer pricing),
dilution of minority shareholders, asset stripping and delay, or non-payment, of dividends.

One of the aims of good governance should be to introduce checks and balances to create the
conditions necessary to facilitate external finance. This view is apparently supported by a number of
studies including those by CLSA Emerging Markets. Its first, entitled The Tide's Gone Out: Who's
Swimming Naked? and published in October 2000, evaluated the corporate governance practices
and performance of 115 large cap stocks in 25 emerging markets. The study found that the price of
shares of those companies with high corporate governance standards has been more resilient during
market downturns.

The study commented: "...those (companies in the survey) with weaker governance see their shares
collapse when market turmoil results in a higher discount for mismanagement. Transparency,
accountability, independence, fair treatment of minorities, management discipline and responsibility
Ͷ key features of good governance Ͷ are crucial in assessing and reducing investment risks in
emerging markets." Similarly, the study also showed that the price of the shares of companies with
good governance have significantly outperformed. Taking this a stage further, higher share prices
should therefore lead to a reduction in the overall cost of capital.

Later studies by CLSA in 2002 and 2003 have reinforced these earlier findings. CLSAs most recent
study published in May 2003, confirmed that corporate governance remains a key to investment
decisions and valuation metrics at both the macro and micro levels.

Standard & Poor's own Transparency & Disclosure study covering 1,600 global companies found a
correlation between high standards of transparency (often a leading indicator of higher governance
standards) and price-to-book ratios, reinforcing the view that the market rewards those companies
with higher standards.

On a macro level, other studies have shown that in countries where higher investor protection
measures existed, and where corporate governance standards were higher, the impact of economic
crises was, relatively speaking, less. Studies in the US have examined the depreciation of currencies
and the decline of the stock markets in a number of emerging economies during the Asian crisis of
1997-98. The studies revealed that countries with higher standards of investor protection were,
relatively speaking, better insulated against market turmoil than those countries where investor
protection laws were weak.

The annual survey of global institutional investors by the management consulting firm, McKinsey,
also found that these institutional investors said that they would be willing to pay a significant
premium for the shares of companies that they knew to be well-governed. In fact, some investors
stated that good governance practice was a key determinant of whether they would invest in a
particular company or not. Not surprisingly, the average premium differs from country to country.
Companies domiciled in countries with high governance standards can expect to pay significantly
less than companies in countries where standards are low.

Similarly, companies with contrasting governance practices domiciled in the same country can
expect significantly different premiums from investors. Even in the UK, generally recognized as one
of the stronger environments for corporate governance, investors say they will pay up to 14% more
for the shares of well-governed companies.

McKinsey's findings are consistent with good risk management practices, where logic dictates that
investors should pay a premium to reduce risk (in this case, risk associated with poor governance
practices). Conversely, these investors should expect to receive a discount for assuming greater risk.

On a more fundamental basis, investors often cite poor corporate governance practices as the
reason for not investing at all, or for reducing the level of investment in a particular stock.

For all the above reasons, the need to introduce standards of corporate governance and build
greater transparency in emerging markets is increasingly recognized. The OECD and multilateral
development banks, for example, are actively seeking to improve awareness and conceptual
understanding of corporate governance, and to encourage both governments and companies to take
practical steps to improve corporate governance practices.

At the government level, emphasis is placed on encouraging the building of a strong legal and
regulatory environment, and this includes evaluating the effectiveness and enforceability of existing
laws, as well as the level of transparency and disclosure required by the market.

At the company level, this means adapting governance practices consistent with increasingly
accepted principles of corporate governance in global markets, however, there is no one model of
corporate governance that works in all countries and in all companies. Indeed there exist many
different codes of best practice that take into account differing legislation, board structures and
business practices in particular countries. However, there are standards that can apply across a
broad range of legal, political and economic environments. For example, the Business Sector
Advisory Group on Corporate Governance to the OECD has articulated a set of core principles in
corporate governance practices that are relevant across a range of jurisdictions. These are: fairness,
transparency, accountability and responsibility.

 
   

 

In 2001, Standard & Poor's launched a new service, Corporate Governance Scores, to evaluate
corporate governance practices, both at a country and a company level. The aim was to introduce a
principles-based approach to governance analysis, focusing on substance rather than form, and to
avoid the models-based, box-ticking approach often adopted by others.

The analysis was divided into micro and macro aspects of governance:

 

 

Firm level analysis evaluates corporate governance practices at individual companies. Using a
synthesis of the OECD's and other international codes and guidelines of corporate governance
practices as cornerstones of the scoring method, Standard & Poor's assigns scores to a company's
overall governance practices and four individual components (see below).

A company's Corporate Governance Score (CGS) reflects Standard and Poor's assessment of a
company's corporate governance practices and policies and the extent to which these serve the
interests of the company's financial stakeholders, with an emphasis on shareholders' interests. (For
the purposes of the CGS, corporate governance encompasses the interactions between a company's
management and its board of directors, shareholders and other financial stakeholders.)

A CGS is awarded on a scale from CGS-I (lowest) to CGS-10 (highest). In addition, the four
components, described below, all contribute to the CGS and receive individual scores from I (lowest)
to 10 (highest).

Standard & Poor's analyzes the four main components, and their sub-categories, to evaluate the
corporate governance standards of individual companies. These four components and the sub
categories are as follows:

 



   





Sub-categories:

÷Ê transparency of ownership;

÷Ê ownership concentration and the influence of external stakeholders

 

    
   


Sub-categories:

÷Ê shareholder meeting and voting procedures;

÷Ê stakeholder relations (including non-financial stakeholders);

÷Ê ownership rights and takeover defences.

 

 
 
   


Sub-categories:

÷Ê content of public disclosure;

÷Ê timing of, and access to, public disclosure;

÷Ê audit process.

 

    



Sub-categories:

÷Ê board structure and independence;

÷Ê role and effectiveness of board;

 ÷Ê directors and senior executive compensation.

 
  




The purpose of country analysis is to determine the extent to which external forces at the macro
level support the internal governance structures and processes at the company level.

The external environment can be important in motivating good or bad internal governance practices
by individual companies. It is also of importance in defining:

÷Ê The rights of financial stakeholders and how these have an impact on the company's
relations with its financial stakeholders.

÷Ê How effectively the relevant infrastructure in a given country encourages and protects these
rights.

The first attempts to clarify what stakeholder rights exist as defined by legislation and regulatory
practice. The second addresses the relevance of these rights in practice.

In addition to an assessment of pertinent laws and regulations, the analytical process may involve
discussions with investors, company directors, lawyers, accountants, regulators, stock exchange
officials, economists and relevant trade associations.

The four main areas of focus in this analysis are:

÷Ê legal infrastructure;

÷Ê regulation;

÷Ê information infrastructure; and

÷Ê market infrastructure.

The country analysis includes assessments of each factor.

The Country Governance Evaluation reflects the degree to which the legal and regulatory, and
informational and market environments provide a supportive infrastructure for effective corporate
governance.

A strong country support environment will not mean that an individual company from that country
will automatically be highly scored itself. There is no floor because an individual company in a
positively assessed country can receive a low CGS if so warranted.

Conversely, because the analysis focuses on what a company does, rather than what is required by
law or regulation and benchmarks a company's corporate governance standards to codes and
guidelines of good corporate governance practices, there is no sovereign constraint. A weak
environment will not necessarily mean that a company will receive a low CGS. It is entirely feasible
that a well-governed company in a negatively assessed country may receive a high CGS.

Although Standard & Poor's Governance Services analyzes individual countries, it does not assign
country governance scores. However, Standard & Poor's sovereign credit ratings can serve as a proxy
for governance risk at the country level. Standard & Poor's own research has identified a remarkably
close correlation between these sovereign credit ratings and its own and others' analysis of country
governance risks.

Corporate Governance Scores allow the comparison of individual companies within a national
context as well as comparisons of companies in different jurisdictions. This concept is reflected in
the graphic below which isolates country and individual firm governance standards on a two
dimensional matrix. While Firm A and Firm B may have a similar level of overall governance
standards, the fact that Firm A is in a more protective country environment than Firm B suggests
that the greatest investor protection is for Firm A given that it is domiciled in a country with a more
robust supportive environment for good governance practice.

There is limited empirical evidence linking individual company scores with the country environment.
However, it is reasonable to assume that the two are positively correlated. In other words, high
governance standards might be expected in countries that reflect strong legal, regulatory and
informational infrastructures; the opposite would be the case in countries that score low in this
macro assessment. This is reflected in the hypothetical distribution reflected below. This
hypothetical distribution is broadly consistent with Standard & Poor's own experience in corporate
governance scoring.

However, it is important to note that it is also reasonable to expect outliers (that is, cases of strong
firm governance in weak country environments) and vice versa. In many ways these outliers are the
most interesting situations to assess, and need to be properly identified.

In this context this two dimensional matrix can be further subdivided into four quadrants, as
reflected in the diagram below.

The north-east and south-west quadrants might be labelled the Expected Distribution because they
reflect the assumption of a positive correlation between company governance standards and the
overall country governance environment. The north-west and south-east quadrants reflect the
outliers, and can be divided into two very different groups:

Under-achievers: companies in strong country environments whose own governance standards have
not met high standards (for example Enron, WorldCom, HealthSouth in the US).

Over-achievers: companies in weak country environments whose own governance standards can be
viewed as high relative to the country of domicile (for example Infosys in India).

In this schema, clearly the under-achievers will have little or no incentive to have their governance
standards publicly scored. However, the overachievers Ͷ mostly from emerging economies Ͷ are
likely to have the greatest interest in receiving a governance score so as to differentiate their firm
positively from local peers with lower governance standards.

GRAPH: Country/Company Analytical Framework

GRAPH: Hypothetical Distribution of Corporate Governance Scores

GRAPH: Country versus firm risk: a two dimensional perspective