Vijaya B. Marisetty
A. V. Vedpuriswar

THE recent worldwide accounting scandals have underscored the role of corporate governance in protecting the interests of investors. However, the growing awareness of corporate governance has also made it more difficult to define good governance.

The complexities behind corporate governance arise on account of two reasons. First, the multi-disciplinary nature of the subject. Among other disciplines, accounting, financial economics, law, philosophy and political science have linkages with corporate governance.

The second factor is cultural diversity. Anglo-Saxon countries such as the US and the UK equate corporate governance with firms pursuing the interests of shareholders. Whereas in Japan, Germany, and France, corporate governance is concerned with the interests of a wider set of stakeholders, including employees, customers and shareholders.

A more accurate system of measuring corporate governance must be in place if the standard of corporate governance in the country is to be improved. In today's market economy, notwithstanding some limitations, it is market reaction which provides the best measure of corporate governance. The way the market reacts to information about a company says a lot about corporate governance. In other words, market reactions depend on the quality and timeliness of disclosures. Even from a larger societal point of view, companies must make timely disclosures to the investing public to facilitate reasonably quick, if not immediate, adjustment of share prices.

Mispricing is bad for society because it leads to sub-optimal capital structures resulting in inefficient usage of scarce resources. Thus, a company with overpriced shares attracts more equity capital than it requires from investors, while one whose shares are underpriced attracts less than it needs. In both cases, the economic resources are being diverted to less optimal uses.

Regulators, market structure/design and market participants have an equally important role to play in ensuring instantaneous adjustment of stock prices to information. If one assumes that most of the mispricing is due to poor corporate governance, the following hypotheses must hold good.

  • Well-governed companies should have less mispricing than badly-governed ones;
  • Firms practising good governance should have less private information.
  • Companies with good governance should have lower volatility compared to bad governance companies. They should make timely disclosures, thereby ensuring that the stock price does not overshoot or lag the intrinsic value significantly.
  • These hypotheses were used to test some leading Indian companies. Standard and Poor's (S&P) corporate transparency rating of Indian companies was used as the basis for identifying good and bad governance companies. The S&P ranking, which covers around 50 Indian companies, takes into account corporate structure and investor relations, transparency and information disclosure and management structure and processes.

    While companies make announcements about various events, four events were selected, which vary with respect to the nature of information, private or public dividends, merger/takeovers, preferential allotment and sale of assets.

    Dividends have a higher degree of public than private information. This is because analysts follow dividend announcements closely and information on historical trends is easily available. Mergers/takeover events, due to their price sensitivity, have more private information. But some analysts may discern signals ahead of mergers/takeover announcements by tracking prospective companies' interactions. The remaining two events preferential allotment and sale of assets have the highest degree of private information.

    In theory, bad governance companies should exhibit more mispricing than good governance companies during these four events. The mispricing should be more if the event has a higher degree of private than public information. These hypotheses were tested by examining the reaction of the markets when companies make announcements about important events. In India, the average mispricing is low for good governance companies compared to bad governance companies. The level of over/under-pricing is not that high for merger/takeover and dividend announcements. In support of this, it was found that there is more private information before the announcement of sale of assets and preferential allotments for good governance companies.

    All this goes to show that despite the efforts by many leading companies to improve corporate governance, there is still a long way to go. Even the best governed companies need to improve their disclosures. They have to do much more to minimise private information, by making disclosures on a timely basis. Only then will mispricing be minimised, if not eliminated.

    By constantly monitoring how the markets are responding to announcements of events by companies, regulators and market analysts can create the necessary pressure for improving disclosures and, consequently, corporate governance. Indeed, this may be as, if not more, effective as the numerous committees set up to streamline corporate governance practices in India.

    (Vijaya B. Marisetty is with Monash University, Australia. A. V. Vedpuriswar is Dean, Institute of Chartered Financial Analysts of India, Hyderabad.)

    (This article was published in the Business Line print edition dated July 8, 2005)
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