CG Rating & Corporate Insight

CGR is the independent assessment of corporate governance practices followed by companies. It

contributes to the process of open, transparent, and timely information sharing in a market with
information asymmetry. It empowers market participant to assess the level and quality of corporate
governance. This reduces risk premium associated with the equity investment and further decreases price
volatility.
The issues surrounding shareholder monitoring and disciplining of management were first explored in the
1932 classic, The Modern Corporation and Private Property. Most corporate governance approaches
ultimately leave professional managers unaccountable to shareholders. 2 Other observers have
postulated-that institutional investors are the group most likely to manage and resolve corporate
governance issues.
After all, ownership of the vast majority of public companies on the NYSE and NASDAQ (NMS) is
concentrated in the hands of institutional investors, who should have a vested interest in reducing the
“agency costs” that arise when management pursues interests that are at odds with those of the
shareholders – such as lavish options grants or ill -starred acquisitions.
Besides, many institutional investors now equate poor governance with a significantly higher investment
risk, there was also money to be made in providing such information to ratings to institutions. The
significance and influence of these services should not be underestimated.
How Are Companies Scored?
Fundamentally, each of the services assess and benchmark corporate governance and disclosure
practices, and then provide the results of to investors, credit providers, insurers and other stakeholders.
The reports are paid for predominantly by institutional investors (both equity and debt), and to a lesser
extent by the companies themselves. The most significant uses of the reports are to advise investors on
matters being voted on, effect corporate change by recommending improved governance standards, and
to serve as an evaluation tool for prospective investors.
Increasingly, the investment committees of many institutional investors will not invest in a company with
a poor corporate governance and disclosure score due to their liability under a “fiduciary duty” legal theory.
Thus, companies with low governance ratings may be expected to trade at a discount to comparable
companies with strong governance principles.
The rating process includes a review of both public and confidential information, as well as interviews with
senior company representatives, including directors. The survey generally covers four key areas:
 Ownership structure and external influence
 Shareholder rights and stakeholder relations
 Transparency, disclosure, and audit
 Board structure and effectiveness
Following the assessment, the corporate governance rating agency will produce a “score,” which reflects
the extent to which a company’s corporate governance practices and policies serve the interests of
investors, shareholders, and other stakeholders.

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CG covers a number of internal and external mechanisms that reduce agency cost within a corporation and
thereby lead to an increase in firm value. In case of emerging economies including India, family owned
companies dominate the corporate scenario. Thus, there are many issues like multiple directorships, board
size and duality apart from board independence which may affect board decisions by substantial equity
stake and holding important managerial positions.
CG Rating Agencies
Credit rating agencies are agencies which provide ratings to represent objective analyses and independent
assessments of companies, entities or countries that issue such debt securities. These ratings are an
indication to the buyers of this debt how likely they are to be paid back.

 Core Functions of a Credit Rating Agency

 Compiling financial data essential for loan decisions and insurance.
 Statistical assessment that is involved in ascribing a rating to a borrower.
 Providing investors an objective analysis of the organization’s ability to pay back.
A credit rating issued by a rating agency is an assessment of the creditworthiness of securities issued by
corporations, governments and other entities. The ratings given to such securities are mostly represented
as AAA, AAB, Ba3, CCC etc. It is very similar to a marking system wherein the highest rating AAA is given to
a borrower who has the highest probability of paying back. In that way, AAA is considered to be one of the
safest debt securities to buy.
Importance of Credit Ratings
Credit rating represents an objectively analyzed assessment of the creditworthiness of the borrower. So,
the scorecard affects the amount that companies or governments are charged to borrow money. A
downgrade, in other words, pushes down the value of the bonds and raises interest rates. These, in turn,
influence the overall investor sentiment concerning the Borrower Company or Country.
If a company perceives to have undergone a downturn in fortunes and its rating is lowered, investors might
ask for higher returns to lend to it, thereby judging it to be a riskier bet. Similarly, if the economic and
political policies of a country look gloomy, its ratings are downgraded by global credit agencies thereby
influencing the flow of investments in that country.
Globally, Standard & Poor’s (S&P), Moody’s and Fitch group are recognized as The Big Three credit rating
agencies. In terms of acceptability and influence, these three collectively have a global market share of
95% as per the CFR report, USA 2015. The Indian credit rating Industry has also evolved with the emergence
of professionally competent agencies like CRISIL, ICRA, ONICRA, CARE, CIBIL, SMERA, and others.
CG Rating (CGR) is non-mandatory in India. Only eighteen companies have their ratings in public domain.
It was first introduced by Crisil Ltd, an associate of global rating agency Standard and Poor’s in 2003.
This was followed by two other rating agencies, ICRA Ltd and Credit Analysis and Research Ltd (CARE).
These three agencies have rated around 50 firms, but only 18 have disclosed their ratings.
These ratings are voluntary and companies have the right to accept or reject them. Due to its voluntary
nature, only firms having urged to improve CG or are sure about their governance standards approach the
rating agencies.

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Anecdotal evidence state that firms having an expectation mismatch avoid displaying their ratings. The
companies serious about improving their governance standards opt for the assessment and diagnostic
tools offered by these agencies instead of CGR. The rating methodology is silent on the way index is
constructed.
CORPORATE CRITERIA FRAMEWORK
On a macroscopic level, these changes affect economic policies of a nation. An endorsement from a
convincing rating agency makes life easier for countries and financial institutions issuing bonds. It basically
tells investors a firm has a track record and indicates how likely it is to be able to pay back the money.
Country Risk
• Economic

CICRA
• Institutional and Governance

• Legal

• Financial System

Industry Risk
• Industry-specific growth trends

• Market structure & competition

• Industry cyclicality

Company Risk
• Competitive advantages

• Scale, scope, & diversity

• Operating efficiency

• Profitability

Standard & Poor’s Ratings Services’ corporate analytical methodology organizes the analytical process
according to a common framework and divides the analysis into several steps so that we may consider all
salient factors. The first step is analyzing a company’s business risk profile, followed by an evaluation of its
financial risk profile. We combine
our assessments to determine an issuer’s anchor. We then take several subsequent analytical steps using
forward-looking analysis and analytic judgment to determine the ultimate rating conclusion with the goal
of transparency and rating comparability. Underpinning the entire framework is financial analysis
comprising reviews of historical financial statements, analytic adjustments, and cash flow forecasts.

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Elements of CG Index
The Board of Director
The Board of directors are the backbone of corporate governance as they decrease agency cost by
monitoring and rewarding top executives, leading to shareholders wealth maximization. They are
accountable for setting objectives, monitoring and controlling firm’s actions, which aligns managers and
shareholders interest.
Percentage of Independent Directors
The finance literature argues that boards with a majority of independent directors are efficient in
monitoring management (Bhagat and Black, 2002) which is also grounded in agency theory. Thus board
with higher proportion of independent director is preferable.
Total number of directorships and committee membership held by directors
Multiple directorships and committee membership by directors may hamper the ability to discharge their
duties effectively. Indian regulators have tried to limit multiple directorships to fifteen and committee
membership beyond ten or five in case of chairman position in committee. It is mandatory for every
director to inform the company about the committee positions he occupies in other companies and notify
changes when they take place.
CEO duaity
CEO and Chairman’s role is profound in a company, while CEO is responsible to board for overall strategy,
investment and for managing day to day activities; chairman ensures that board activities are carried out
with due diligence and timely information is provided to board. A combative issue in CG is whether these
roles are detached or aggregated in one person. These roles differ fundamentally in nature and emphasis.
Separation of the roles is grounded in agency theory of CG to prevent managerial abuse. Agency theory
advocates separation of Chair and CEO roles as it increases the board’s independence from management
leading to better monitoring and oversight. The committee appointed by the CII recommends that if the
chairman and CEO (or MD) is the same person, Independent directors should constitute 50% of the board
and 30% of the board otherwise. The Clause 49 regulations, while silent on CEO – chairman duality seem
to give more importance to the reduce supervision view.
Board Size
The board’s size and composition also influence firm’s ability to function effectively. Larger boards lead to
inefficiencies due to enhanced difficulty in achieving agreement concerning decisions. Studies advocate
smaller boards, as they experience less communication and coordination problems. Board size should be
either seven or eight for optimal financial performance. Large boards lead to communication gaps and
coordination problems and consequently negatively affect financial performance. However, CEO dismissal
in case of poor performance is likely in small boards.
The Audit Committee Sub Index
This internal CG mechanism depends on availability of accurate and timely information. The audit
committee as a mechanism assures company produces relevant, adequate and credible information that
investors as well as stakeholders can use to assess the performance of the company.

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The audit committee needs independence from management which is very important during verification
of financial statements prepared by internal auditors and management.
A summarized statement with related party transactions in ordinary course of business as well as
transactions which are not in the normal business course should be placed periodically before audit
committee. Details of material individual transactions with related parties and others, which are not on an
arm’s length, should also be placed before the audit committee along with management’s justification for
the same.
Making the Grade: Managing Your Corporate Governance Rating
Governance ratings services are becoming a very powerful (if somewhat subjective) source of information
on a company’s commitment to excellence in its governance practices.
Some best practices are recommended in order to effectively deal with this new force in the investor
relations landscape-
1.Appoint an executive to monitor rating services. Given the broad potential impact of these ratings and
the fact that rating methodologies are still in flux, companies would be well advised appoint a point
person to accumulate rating information, understand the basis for each rating service score, communicate
such information to senior management and the board of directors, and act as a catalyst
for improving ratings. This role could be filled by a CFO, controller, general counsel, or investor relations
counsel. An important task for this officer is to monitor the agencies for mistakes and correct those
mistakes. It has been reported that many companies have had their ratings lowered due to mistakes
contained in various outside reporting services such as Bloomberg, which are then reflected i n the rating
service analysis.
2.Develop a robust corporate governance section on Web site and in periodic reports.
Equally important as adopting progressive policies is to provide investors with comprehensive governance
information in an easy -to-access manner. The trend among high-quality companies is to separate such
information in a corporate governance section of its Web site as opposed to simply providing a link to
required information on the SEC’s E DGAR system. Among the key elements included in the corporate
governance section are bylaws, code of conduct and ethics, board of directors’ information. Equally
important as adopting progressive policies is to provide investors with comprehensive governance
information in an easy -to-access manner.
3.Publicize the ratings: it would be appropriate to discuss governance policies and philosophy in investor
presentations and publicize the company’s governance rating in a press release.

Integrating Governance in Credit Assessment Scorecards

As shown in Figure, governance is included in the Scorecard framework as one of the four elements making
up the wider management and governance (M&G) dimension. The assessment of M&G acts as a modifier
to the anchor, just before the assessment of an entity stand-alone credit profile.

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In the Scorecard framework, governance can either have a neutral or negative impact, but cannot enhance
a credit assessment. This is because stronger M&G practises are expected to have already manifested
themselves in stronger competitive positioning and more balanced financial risk profiles.

Conversely, poor planning and controls, lack of independence and preparation, and legal and regulatory
infractions can be regarded as early-warning signals of a firm´s weakening business and financial
conditions. A single governance deficiency does, accordingly, act as a modifier to the credit assessment.

M&G in Scorecards

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