corporate governance rating - a research perspective by joffy george 6

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Corporate Governance Rating - A Research Perspective Joffy George, ACS, Kerala. e-mail : [email protected] A new tre nd in ensuring Corpo rate Governance compliance is corporate governance rating. Differential rating for different compliance levels will bring in the much needed public fa ith. High Corporat e Governance Rating is also expected to increase the company's value. It has all the potentials to gain respectability like credit rating. Introduction t o Corporate Governance Rating Undoubtedly , corporate governance is a hot topic across the globe. Not a day seems to go by without press comment, conference or the launch o f new code, all on the subject of Corporate Governance. The increasing number o f corporate scandals in the last few years have affected Corporate Governance reputation and questioned the effectiveness of its current structure. As a result, Corporate Governance ha s received attention from policymakers, investors, corporate boards and rating agencies. During this period, many top executives o f giant corporations, such as WorldCom Inc., Enron Corporation, Tyco International Lt d ., Adelphia Communications Corporation, Credit Suisse First Boston, to name a few, have been convicted o f conspiracy, orchestrating schemes to hide their company's debt and exaggerate profits while embezzling millions o f dollars. Shareholders as well as legislators have been appalled at such in tolerable actions . These actions and practices have created an urgent need for Corporate Governance assessment and rating systems. Agency problem paving wa y fo r Corporate Governance Rating Corporat e governance is o f major practical importance because it deals with the ways in which shareholders and banks assure that managers work for long-term interest o f the company and for maximiz ing investor's returns . The main issue that Corporate Governance tries to resolve is the agency problem, arising from the separation o f ownership and control and the uncertaint y financiers have that their fund s will be invested in attractive projects. Th e agency problem is also an essential element of the so called contractual view of firm. 1 Ideally a contract can be signed between managers and financiers that specify exactly how the manager should perform his duties and how the profits should be alloca ted. However, this solution is very complicated to apply in practice. Most managers have significant cont rol on how to allocate investor's funds. Jensen 2 argued that a manager would undertake a project that could give him personal benefits, against investor's interests, i f he has the opportunity not to return the money to the investors. This is the free cash flow theory where a manager chooses to reinvest free ca sh rather than return it to investors. Moreover, Shleifer and Vishny3 argued that managers are able to retain their position even when they are no longer competent or qualified to run the company. A better solution to this agency problem could be a long-term incentive contract that aligns managerial interests with those of investors. Incentive contracts can include share ownership, stock options or even a risk o f dismissal. 4 Holmstrom 5 argued that th e optimal incentive contract is determined b y th e manager's risk aversion and the relevance o f his decisions. However, there may also be problems with such incentive contracts when they give the opportunity to the managers for self-dealing, that is to negotiate with themselves the terms o f the contract. In line with this argument, Yermack 6 shows that I. Coase, 1937; Jensen and Meekling, 19 76; Fama and Jensen, 1983. 2. Jensen (1986) What 's a Director to Do? 3. Shleifer and Vishny (1988) Alternative Mechanisms for Corporate Control. 4. Jensen and Meekling, 1976; Fama, 1980; Davis et a/ , 1997. 5. Holmstrom (1979) Moral Hazard and Observability. 6. Yermack (1997)Compensation and Top Management Turnover.

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