Corporate Governance in an Emerging Market – What Does the Market Trust?

Abstract

The recent corporate governance scandals at the fourth largest software firm in India, Satyam Computers Limited, provide two clean and major corporate governance events, with effects on firms across the board in India (and possibly other emerging market countries). The first instance was a shock about board ineffectiveness on Dec 16, when Satyam’s board approved of an acquisition of two companies – one unlisted – where members of the Chairman’s family were the main entrepreneurs and had majority or complete shareholding; and the second, an accounting shock, occurred on January 7 when it was disclosed that the firm had been fudging its accounts for several years and its much-vaunted $1.2 billion cash holding was largely non-existent and the result of a long-drawn accounting fraud. We analyze the cross-sectional variation in the stock price reactions to these two corporate governance shocks for Indian companies. We relate the firm-specific cumulative abnormal returns on these two dates to different measures of corporate governance to find out the market perception of the validity of these measures. We show that with regard to board effectiveness, i) Board independence matters; ii) the characteristics of the independent directors also have a favorable effect on market reaction: companies with independent directors having more expertise (proxied by number of multiple directorships) do better; iii) institutional holdings have a salutary effect, but only for foreign institutions; iv) board size has a positive effect on market reaction; and v) there is a large discount for companies belonging to business groups. For the second episode, none of the board or audit committee independence related variables are significant, but indicators of quality of audit committee seem to matter. The discount of group companies becomes even more pronounced in this episode. These findings help us identify what variables among those identified by prior research are actually taken into account by investors in an emerging market to assess the corporate governance levels of companies and to what extent they affect valuation.