The Hindu Business Line : How corporate governance rating would help

A RECENT news report suggested that the Securities and Exchange Board of India is considering a proposal to rate initial public offers (IPO). The rating would cover only the promoters' track record and company's financial performance. In effect, SEBI is attempting to improve the corporate governance practice in the country.

The rating should, however, extent to rights and public offers. Besides, stock exchanges should demand minimum corporate governance rating under the Listing Agreement. The reason is that companies may not voluntarily disclose information, especially those with limited institutional investor interest. The disclosure of such a rating (change) may lead to better price efficiency in the market and lower risk premium for companies.

Corporate governance: The European Corporate Governance Institute defines corporate governance as the "basis of accountability in companies, institutions and enterprises, balancing corporate economic and social goals on the one hand with community and individual aspirations on the other".

Essentially, then, corporate governance in the context of public and rights offers would refer to the quantitative and qualitative disclosure of information about the company and its management.

Price efficiency: The capital market prices risk. Now, investors demand high risk-premium because of information asymmetry. Asymmetry arises because the management knows more about the company's future than the shareholders do. If corporate governance rating were available, investors can gauge the level and the quality of information disclosure. That could bring down the risk premium, and, perhaps also lower the abnormal volatility in asset prices.

An improvement in corporate governance practice could also lead to better price performance. After all, a lower risk premium means higher price-earnings multiple (PEM) for a stock. This behaviour can also be explained intuitively. Investors demand more shares of a company that has improved its corporate governance practice. And higher demand leads to higher PEM, other factors remaining the same.

Providing more information to the investors also augurs well for the company in the long run. Lower risk premium means that a company can price its stock higher in a public offer for the same level of per share earnings.

Market forces: A question may arise as to whether corporate governance rating is required for companies that are listed on the stock exchange. The argument is that the market prices risk better. Studies have shown, for instance, that a credit rating upgrade or downgrade comes long after the market captures the information in the stock price. If the same logic were to be applied for corporate governance rating, it is only logical to conclude that such a rating change will be also slow.

But there is some merit in having corporate governance rating for listing companies as well. The reason is that there is high level of noise trading in stocks where institutional investor interest is low. Retail investors may, therefore, find it difficult to discern whether a change in the stock price is because of change in corporate governance or other factors. While media reports may conjecture the reason for the sharp change in a stock price, an update on the corporate governance rating by a rating agency authenticates the information.

Of course, investors cannot effectively use the rating change in their decision-making process because of time lag in the rating agency announcing such changes. Nevertheless, changes in corporate governance rating could be a useful piece of information in the same way as credit rating changes. Frequent upgrades and downgrades in the corporate governance rating of a company, for instance, can warn the investors of the high risk associated with the investment.

Importantly, the stock exchanges should collect a fee for corporate governance rating as part of the Listing Agreement from all companies. The stock exchanges can in turn pay the rating agency. This way, the perception that a rating might not be independent because the company pays the rating agency can be avoided.

Shareholder activism: Finally, improved corporate governance does not end with the company. Shareholders have an important part to play as well.

As Graham and Dodd observed: "The choice of a common stock is a single act, its ownership is a continuing process. Certainly, there is just as much reason to exercise care and judgment in being a shareholder as in becoming one".

There is a positive secondary effect on shareholders demanding better corporate governance. When more information is available, institutional interest in a stock increases. Higher institutional interest leads to better price efficiency.

Response may be sent to: bvenky@thehindu.co.in

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