Market Initiative - Governance and Value Creation Rating

While a lot has been done in the filed of corporate governance, we need to advance it to the centre-stage of corporate operations. Otherwise, it would remain as an ineffective side agenda, which will get a lot of lip-service but would never be used as the important tool in improving corporate behaviour. In order to bring it to centre stage, we must have an unambiguous yardstick which can be used to measure and monitor the progress on the path of corporate governance.

Indian market has developed such a yardstick in the form of ‘Governance and Value Creation Rating (GVC)’ architectured by CRISIL, a leading credit rating agency in India and one of the four largest agencies in the world. This is significantly different from the ‘Traditional Corporate Governance Rating (TCG)’, which is available in several regulatory jurisdictions. The GVC approach stems from the belief that good governance, over and beyond its process aspects, is fundamentally a sustainability issue - good governance should result in the creation and fair distribution of tangible benefits. It is based on the following premises:

• The strength of stakeholder relationships can add to/impede future wealth creation by the corporation

• Governance processes must be such that wealth created is evenly distributed across all classes of stakeholders.

• Management quality must be such that it is able to adapt the above two to match the dynamics of the business environment

Role/Contribution of Other Stakeholders towards Success of the Corporation

• All these impact stability of future wealth creation While the corporate governance is expected to enhance the interests and fulfil the aspirations of all stakeholders, it does not necessarily happen always. While the ultimate purpose of all corporations is to create wealth for its shareholders, it is important to recognise that shareholders are indeed the residual stakeholders. The obligations towards the contractual stakeholders such as customers, employees, vendors, creditors and the society get precedence over the interests of the shareholders. The contribution of other stakeholders to the success of the corporation is not less important than that of the shareholders. Unless the company blends a harmonious relationship among all the stakeholders, it may jeopardise its ability to create wealth on a sustained basis. The GVC rating seeks to capture this sentiment.

Before describing the process, it is worthwhile to briefly indicate the distinction between TCG and GVC ratings. While the TCG rating primarily focuses on internal processes, GVC rating seeks to balance process assessment with an assessment of the benefits of good governance; TCG rating focuses on the treatment and rights of shareholders, while GVC rating aims at balanced assessment for all stakeholders; and TCG rating is either qualitative or purely historical in orientation, while GVC rating focuses also on sustainability of practices.

Under the GVC assessment, the shareholders have a residual entitlement, while all other stakeholders have contractual entitlement to the value created by the company. The customers benefit from using the company’s products and services. The suppliers benefit from steady and profitable sales to the company. The society benefits from receipt of taxes, generation of employment, and social commitment displayed / public projects undertaken by the company. Lenders benefit from safety of interest and principal, and also gain from enhancement of their portfolio quality through improvement in the quality of their lending / investment portfolios. Employees benefit from salaries and benefits, and through stability of employment. The residual belongs to shareholders – majority and minority - and shared appropriately.

The board and management are expected to create value for all the stakeholders. Hence,governance processes must be such that wealth created is distributed across all classes of stakeholders in proportion to their contribution, and in keeping with market and business practices. It is in this perspective that the quality of management should be enhanced so thatit is able to adapt to match the dynamics of the business environment. Eventually, all these decisions of company impact stability of their future wealth creation.

The GVC assessment process of CRISIL. It comprises assessments of:

1. Governance processes:: The factors assessed include treatment of shareholders, safeguarding ownership rights / interests of shareholders, transparency and disclosure, composition and functioning of the board etc. The assessment evaluates how governance processes are conducive to these factors and the true spirits at work.

2. Wealth Creation:: This is assessed in detail for each kind of the stakeholder. The finances of the company are assessed with a view to understanding the level of wealth creation (inputs minus outputs), particularly with reference to macroeconomic environment and micro industry environment and if the wealth has been created in a manner beneficial to all stakeholders. A methodology similar to Economic Value Addition (EVA) is used for this.

3. Wealth Management This is assessed across the stakeholders. The wealth generated from management of inputs and the functioning of the organisation has to be managed well. The wealth must at all times remain on multiplier matrix so that it grows optimally. Even if the wealth is being utilised for purposes other than the core businesses and activities of the company, it should be for the ultimate good of all the stakeholders in the medium and long term.

4. Wealth Sharing: Similarly, GVC assesses if the wealth is being shared proportionately i.e. those who are entitled for contractual sharing get their dues and in time. Further, residual is shared amongst various classes of shareholders proportionately and equitably. There is no disproportionate sharing in particular through instruments like ESOP, Sweat Equity disproportionate compensation etc.

GVC ratings are a globally unique initiative, and are gradually gaining acceptance in the Indian market. Efforts are also under way to propagate it in other markets, both on account of its intrinsic merits as a comprehensive and forward looking measure of governance, and also to create a common language for understanding corporate processes and their effectiveness.

The regulator has been endeavouring to inculcate a culture of corporate governance among the market participants and the listed companies. The Listing Agreement has been amended with a view to ensure, inter alia, the following:

1. Not less than 50% of the board of directors shall comprise of non-executive directors.

2. In case of a non-executive chairman, at least one-third of the board shall comprise of independent directors and in case of an executive chairman, at least half of board shall comprise of independent directors

3. Compensation paid to non-executive directors shall be approved by the shareholders and also disclosed.

4. Independent directors shall periodically review legal compliance reports as also Boards’ Disclosures on Risk Management.

5. Company shall lay down a code of conduct for all Board Members and SeniorManagement.

6. The Audit Committee shall consist of qualified and independent directors. While all the members of the Audit Committee have to be financially literate, the Chairman must be a person, who is well versed in accounting and management. It shall exercise oversight on the company’s financial reporting process. It is empowered to recommend the appointment and removal of external auditors. It is responsible for reviewing the adequacy of internal control systems with the management, and external/internal auditors and also reviewing the company’s financial and risk management policies.

The Companies Act is the basic law to facilitate incorporation and management of companies. A bill proposing amendments in the Companies Act, 1956 is expected to be considered by Parliament to provide for statutory backing to corporate governance standards. The amendment would possibly focus on reforming the audit process and the board of directors.

In order to reform the audit process, the bill is expected to make the provisions for:

1. Laying down the process of appointment and qualification of auditors,

2. Prohibiting non-audit services by the auditors,

3. Prescribing compulsory rotation, at least of the Audit Partner,

4. Requiring certification of annual audited accounts by both CEO and CFO, and

5. Providing an expeditious disciplinary mechanism for the auditors.

In order to reform the boards, following major initiatives are being proposed:

1. The expression ‘Independent Director’ would been defined. Among other requirements, an independent director should not have substantial pecuniary interest or hold more than 2% of the company’s shares.

2. Remuneration of non-executive directors can be fixed only by shareholders and must be disclosed. A limit on the amount which can be paid would also be laid down. It is also envisaged that the directors should be imparted suitable training.

There is thus a concerted effort - the market, the regulator and the government are working in tandem to improve corporate governance in India. There could be no doubt that like the securities market, India would soon be a model for others in the area of corporate governance too.