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Governance and value creation

R Ravimohan | January 24, 2003

The spate of sordid corporate affairs in the past year and a half that swept the Western world has certainly refocused the world's attention on the issue of good governance. Be it tougher regulation a la Sarbanes-Oxley Act in the US, the recent decision to make research more independent, or the spate of committee recommendations on corporate behaviour, it is clear that a broad sweeping broom is clearing some of the murkier aspects that affect governance issues and shield less than adequate performance in the corporate sector.

This wave of scandals has thus far not washed our shores. We have our regular market blow-outs, but none of the corporate frauds. There could be two reasons for the same. Either all our corporates are squeaky-clean, or the system of catching such fraudulent accounting behaviour is not yet fully effective in India. Which one is more obtaining?

For a variety of reasons, in a business-as-usual scenario, most Indian companies would rather understate their profits than overstate them, for that would help them with their taxes and labour settlements, smoothen profits in a bad year and so on.

Unlike the US system where stock options were a clear motivator for managements to maximise profits, which in turn drove the value of stocks, we have a preponderance of family managed businesses here, which don't need the munificence of the stock markets to become rich. That however does not mean all is well.

Interests of minority shareholders, proactive information disclosures, independence of the Board, supervision of managements, compliance with the spirit of law and concern for all stakeholders of the corporate, are some of the issues that require much greater attention. Some of these issues are covered under the traditional methods of evaluating corporate governance. However, other issues are recent incumbents which are generally clubbed with Corporate Social Responsibility.

Globally all these issues are increasingly brought together and tagged as sustainability issues. Pollution control, avoidance of child labour, etc are now being looked at as ways to improve sustainability of operations of corporates rather than as mere good behaviour issues. This is because, sooner or later, such issues either disrupt the operations of a company or introduce an additional cost, thereby reducing profitability. This brings the evaluation of the corporate governance issues into the mainstream, and requires a good understanding of the corporate's behaviour vis--vis each of its stakeholders.

India took a giant leap forward in this paradigm when, under the aegis of the Securities and Exchange Board of India, Crisil launched a new rating product called the Governance and Value Creation Ratings. GVC Rating is a powerful tool that evaluates the behaviour of a corporate towards all of its stakeholders, and also measures the tangible value such behaviour creates for the stakeholders.

By combining these two elements of corporate practices and the tangible output that gets generated as a result, Crisil seeks to directly link the input side parameters of governance practices with the value created on the output side. For good measure, both the governance and value creation are captured for all constituents that form the stakeholders' community for the entity that is being rated.

The rationale that underpins this rating is that the shareholders are the residual interest holders in the corporate entity, after meeting obligations to other contractual stakeholders such as employees, customers, suppliers and indeed the society in which it operates.

Therefore, the corporate has to create enough value to meet all of these obligations before meeting its promise of returns to shareholders. It can do all of these in a sustainable manner only if it enjoys an enduring relationship with these constituencies. Therefore the value creation is critically dependent on and directly linked to the governance practices adopted by the corporate vis-a-vis all of the constituencies that are critical to its operations.

GVC covers in a sense the entire gamut of governance issues, from the input side practices to the outside wealth creation performance. It therefore looks at the tangible measures of results and the intangible factors that influence the decision making process. It explores the structural issues, philosophy of management, robustness of processes, strategies, tactics and capabilities across the spectrum of activities undertaken by the entity.

Conflicts between shareholder groups, their impact on the corporate's ability to create value, the effectiveness of the board in collectively representing the shareholders and its ability to supervise the management, and the management's behaviour towards each of its stakeholders are issues which are seriously examined in this methodology.

Both practices and results are calibrated for each stakeholder to assess the management's attitude, philosophy and capacity to deal with that stakeholder.

Instead of the moral or socialistic protest against inappropriate practices that the CSR espouses, the Crisil GVC rating seeks to negatively mark such practices as possible sustainability issues. For example, if a company engages child labour, the way Crisil will take that into account is to mark down employee stakeholder wealth creation.

It means that the company's profits are unlikely to be sustainable should it not be in a position to continue the practice of employing cheap child labour, either through policy intervention or on account of consumer activism. GVC arrives at the core of the value creation capability of a corporate entity by capturing these embedded risks and exploring the connected governance issues.

The process itself is very interactive and intensive, and comprehensively covers scrutiny of sensitive documents relating to the board, as well as meetings with shareholders, board members, auditors, customers and other stakeholders. Therefore, the outcome is likely to be arrived at after much scrutiny and internal correlation.

The managements and the Boards of the first four companies that Crisil rated on the GVC scale, viz. HDFC, Hero Honda Motors Ltd, HDFC Bank and Dabur India, have to be complimented for showing exemplary foresight. These companies have set a remarkable trend that is likely to set them apart as pioneers in the comity of well-governed corporates.

These entities participated very openly with the rating teams and were as enthusiastic in pursuing the rigours of this exercise as the teams were. They bear testimony to the spirit of good governance that prevails in our country.

The GVC ratings place India at the forefront of governance practices in the world. India's regulatory framework already imposes a fairly high degree of disclosures and reporting standards. We already lead the world in terms of electronic and dematerialised trading, settlement, clearing and risk mitigated trade guarantee schemes.

A wide range of derivative products is also available to offer depth and hedge mechanisms for investors. Combine these with a set of highly regarded professional institutions that put out research on corporate performance, and India is sure to emerge as one of the few quality markets for investors to explore.

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