Why Corporate Governance Matters

The idea of corporate governance is rooted in the objective to separate ownership from management. Since the members of the board of directors do not have 100% ownership of the organization, the board manages the firm as an agent for the shareholders. A movement to reform corporate governance emerged in the 1960’s and early 1970’s as shareholders sought ways to increase share value. The early 1990s witnessed elevated attention on corporate governance in the U.S. as a number of boards dismissed their CEOs. Institutional investors were at the forefront of a surge in shareholder activism to improve corporate governance and to ensure shareholder value. They directed their efforts to dismantle the often too clubby bonds between the board of directors and the CEO (for example, by the unrestrained issuance of stock options, not infrequently back dated). By the early 2000s, the colossal bankruptcies and criminal wrongdoing of Enron and Worldcom, as well as corporate meltdowns showcased by several companies, motivated heightened shareholder and governmental interest in the area of corporate governance. With the passage of the Sarbanes-Oxley Act of 2002, transparency became the buzz word in a climate of increased scrutiny over corporate governance. Today, more than ever, investors are concerned about the quality of corporate governance and how it might affect portfolio performance. The widespread view that ‘governance matters’ necessitates the creation of metrics that allow investment managers to quickly and accurately identify the relative performance of companies vis-a-vis their governance structures. The issue of governance also involved the mutual fund industry where conflicts of interest scandals between mutual fund investors and fund managers happened in 2003. Morningstar, the fund-rating firm Morningstar launched its fiduciary grade system of governance rating. Many academic studies have explored the issue of fund governance and its impact on mutual fund performance and flow of funds to the mutual funds. Again, this area represents another potential avenue for research in the context of an emerging market like India.