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Corporate Governance

The definition and scope of the corporate governance widened, when the Cadbury report
issued in 1993, where it is stated: Corporate Governance is a mechanism to direct and
control the corporate. The expansion in the definition of corporate governance in the form
of word control suggest monitoring the management and employees of the corporate in
the best interest of stakeholders and reducing the opportunities of misappropriation of
resources by management and employees of corporate.
One of the important features of these crises is the ugly side of capitalism. Where the
blind forces of the market drives the managers to invest in the speculative activities so,
that they can maximize their interest from the corporate at the cost of stakeholder’s
wealth. (Hutton, 1995, Hutton and Giddens, 2001)
The central issue in the corporate governance is the structure of corporate and nature of
the business. Which is as follow: the no. of people who purchase the shares, provide the
capital to the corporate and entitled as the actual owners of the corporate. These actual
owners of the corporate select the BOD to look after the affairs of the company. Now
these directors are agents of the company and their duty is to monitor and control the
affairs of the company in the best
Introduction
Using the corporate rating as a proxy for the default risk we want to investigate whether,
the corporate with the strong Corporate Governance has the higher Corporate Rating or
not i.e. the low (high) Default risk.
The Corporate Rating reflects a Corporate Creditworthiness and default risk (Standard &
Poor’s 2002). This is the reason, why rating agencies are concerned with Corporate
Governance, because the poor Corporate Governance does not only destroys the financial
position of the corporate but also results in the losses to major stakeholders i.e. owners
and creditors of the companies (Fitch Ratings, 2004).

The concept of Corporate Governance is important because of separate ownership and


control, which brings conflict of interest among the owners, creditors and Management of
the company. (Jensen and Meckling, 1976).
Since the management of the company formulate the policies, makes the decision,
decides the compensation, comply with the rules and regulations set by the regulatory
bodies and monitor the operations of the business, so they can misappropriate the
resources of the company (Skaife et al. 2006) .While to reduce this misappropriation of
resources; Compliance to rules and regulation, concentrated ownership, BOD
Independence, Quality of Management, Quality of External audit, Procedures and
financial transparency are the other attributes of Governance suggested by S&P 2002.
The Governance Components within these attributes are designed to Monitor the
Management for its quality of policies, and bring the Improvement in the financial
position of the corporate. Which may ultimately reduce the default risk faced by the
creditors and can improve the Credit rating. So, this study reveals that the effective
Governance of management can improve the financial position of the corporate and thus
reduces the default risk faced by creditors for their fixed claims.
Problem
Corporate governance issue is the horizon of research since Adam Smith’s (1776)
publication of An Inquiry into the Nature and Causes of the Wealth of Nation and with
out any doubt the momentum was provided by Berle and Means’s (1932) publication of
the Divorce in ownership and control. After the many years of this publication there is
still misalignment of interests among the stakeholders. The purpose of corporate
governance is decreasing the conflicts of interests among the stakeholders and monitoring
and controlling the firms. The absence of which can decrease the firm value (Dennis and
McConnel, 2003). And thus may increase the default risk of company. Both the internal
and external ways are available to have control and monitor the corporate. One way is to
control through the structure of ownership i.e concentration of ownership and among the
other ways of controlling the corporate is monitoring the board of directors (Jensen,
1993).Because of separation of ownership and control it is required to protect the interest
of stakeholders, due to which codes of corporate governance has been written in many
countries and following this practice in Pakistan these code of corporate governance has
also been written.
Justification of the study
Bankruptcy and default of corporate is because of poor decisions made by the board of
director to expropriate the resources of company. To avoid the expropriations of
resources and monitor the board of directors, code of corporate governance has been
introduced in each country, which is an indication of the importance of the topic. After
the collapse of Enron, debacle of world dot com and other many financial giants the
intellectual groups have acknowledged the default risk is significantly influenced by the
corporate governance practices prevailing in the company. However, scope of corporate
governance is very wide and perhaps it is difficult to cover in few months’ period. The
association of corporate governance with bankruptcy and financial distress has been
observed in many studies, but studies linking the default risk and corporate governance
are very less in numbers (not a single study is available in Pakistan on this topic) and
done on the basis of few attributes of corporate governance and never used the reputation
of the firm as a control variable. Moreover, there is a need of a comprehensive study that
comprised of all the individual attributes provided in various studies of corporate
governance, which is attempted to address in this study.

1.1.6 Scope of the Study:


Though this study focuses the corporate governance as a whole and centered on the
comprehensive corporate governance attributes of compliance, board of director’s
quality, independence, ownership structure, external audit, procedures and financial
transparency and how these all attributes of corporate governance collectively effect the
default risk faced by a corporate. But the study has been limited to the Pakistan only and
did not consider the institutional ownership in the company as an attribute of corporate
governance. However the actual rating score of the sample companies has been used as a
proxy of default risk, which is considered very tedious task in the studies conducted in
past. However the stakeholder’s protection especially of creditor has been kept in mind
and it is tried to look the management from the capacity of making the good decisions to
employing the quality of external and ensuring the financial transparency in the financial
affairs of the company, which is not available in a single study conducted in past on
corporate governance and default risk. Moreover, among

Framework
As discussed in literature review the need of corporate governance is because of
separation of ownership and control. Those who invested the money they are owners of
the company but they are not in control of the business, because of the unique structure of
this business. So, those people which are in control of the business they are agent and
play with the wealth of principal or owner. These agent in the past tried to misappropriate
the resources of principal and the made the regulatory bodies to think about the protection
of shareholders and creditors.

Self – Interestedness Vs Opportunism:


( Popov and Simonova 2006 ) have given various explanations of opportunism by
characterizing the opportunism into five different classes: 1) the principal and agent have
different interests 2) there is asymmetrical information which guides the party with more
relevant information to increase their interests 3) asymmetry information can be
maneuvered so as to avoid the affected parties from fining the agent; 4) the related parties
may have the utility of the information decreased, and; 5) that the operation may be
premeditated and the essential information on the operational process may be destroyed
in the process. That’s why they look opportunism as a intentional hidden act of the agent
on the basis of asymmetric information to achieve personal benefits at the cost of other
relevant parties. Bruce et al. ( 2005 ) in their study about pay performance sensitivity also
agree with Popov and Simonova.
Flow Chart of Study

FINANCIAL QUALITY OF BOD


TRANSPARENCY
COMPLIANCE
INDEPENDENCE OWNERSHIP
STRUCTURE

PROCEDURE
CORPORATE GOVERNANCE
EXTERNAL AUDIT

SIZE

REPUTATION LIQUIDITY
LEVERAGE
GROWTH PERFORMANCE

DEFAULT RISK
( Daily, and Dalton1994). Discuss following issues related with corporate governance
and Bankruptcy. Whether bankrupt firms have joint CEO- board chairperson structure?
Whether board composed of affiliated director increases the likelihood of bankruptcy of
firm? Whether the firm with duality and affiliated directors have more bankruptcy? To
find the answer of first question the data of corporate structure i.e the firms with one
person as a CEO- and board chairman and the firm with separate CEO and Chairperson
was taken and regressed against the financial variables like profitability, leverage etc
using the logistic regression model and observed those firms with joint CEO-chairman
structure has more chances of Bankruptcy. To find the answer of second question, data of
100 firms were collected from 1972-1982. These 100 firms were included the Major
Bankrupt 57 corporation from 1972-1982 and 57survivor firms from 1972-1982.
Proportion of affiliated director is regressed against the financial variable used in this
study like profitability, leverage etc. Using the logistic regression and it has been
observed, as the proportion of affiliated directors in the composition of BOD increases
the bankruptcy increases. To find the answer of third question which is basically the
combination of the first two questions has also been observed using the same data and
observed , as the proportion of affiliated directors and duality in the Board structure
increases a distinguish is created between the Bankrupt Firm and Survivor. Moreover, in
this study it is also concluded that the Corporation with the good qualification of BOD
has strong financial indicators and thus does not lead to the bankruptcy.
Jensen 1993) argues it is ineffective to have the large size of the board. According to him
agency problem with the large no. of directors in the board increases, because of more
conflicting groups representing their own diversified interests. And Free- rider problem
also increase as the few board members stop their duties of monitoring and controlling
the other members of board. Moreover, many companies have a representative from
minority shareholder which does not increases with increase of size of board of director
(Drobetz et al., 2004b). so a board comprised of six to fifteen members is an optimal
board for the improved performance of the company (Brown and Caylor 2004).