The construction of a corporate governance rating system for a small open

capital market: Methodology and applications in the Greek market

Manolis Xanthakis, Lena Tsipouri and Loukas Spanos*

University of Athens, Dept. of Economics

Abstract

The need of institutional investors to evaluate the corporate governance (CG) practices of the
listed companies resulted in many attempts to construct CG rating methodologies. This paper, in
response to this situation, presents an attemp to quantify the compliance of large capitalisation
Greek companies with international best practices. The methodology consisted in the creation of a
questionnaire reflecting the Greek CG code, which basically replicate the OECD Principles.
Other, well-regarded CG codes were taken into account. Then, we contructed a rating system
based on CG indicators and we applied it for the years 2001 and 2003. The total rating results for
the years 2001 and 2003 demonstrated a relatively satisfactory improvement. The highest
compliance is in the category of shareholder rights, while weak compliance appears in the last
category, which incorporates committment to CG, CSR and the relations with shareholders. The
exercise, using practically all agreed principles of the OECD, could demonstrate a reasonable
degree of compliance of the average company rated. Its limitation in that respect is that it could
not satisfy investigations on convergence. The indicators used were highly pertinent to measure
compliance, but not convergence, which was not within the initial targets and would need a
longer time series analysis. Our methodology applies in a small open economy and may have
significant implications in other similar capital markets. Methodologically, the merit of the
exercise lies in its approach toward the creation of "collectively subjective" weightings, and is
valuable to institutional investors, policymakers, regulators and academics.

Keywords: corporate governance; rating; Greece

JEL: G34;G38; G39

*
Corresponding author: University of Athens, Dept. of Economics, Center of Financial Studies, 5, Stadiou
street, 2nd floor, 105 62, Athens, Greece. Tel: +00 30 210 3689390; Fax: +00 30 210 3225542; E-mail
address: [email protected]
§ The authors are grateful to participants at the December 2004 3rd Annual Conference of the Hellenic
Finance and Accounting Association-HFAA (Athens) for helpful comments and discussions and to Alexis
Zervos for reviewing and processing the annual reports. Loukas Spanos acknowledges financial support
from the General Secretary of Research & Technology in Greece and the European Union.

1
Introduction

The upgrading of the Greek capital market to mature market status and the global
competition for capital has boosted the CG debate in Greece. In addition, the recent
corporate failures and financial scandals around the world have increase awareness that
proper corporate governance (CG) is fundamental to the efficient operation of capital
markets. The need of institutional investors to evaluate the CG practices of the listed
companies, resulted in many attempts to construct CG rating methodologies. This paper,
in response to this situation, presents an attemp to quantify the compliance of large
capitalisation Greek companies with international best practices. Firstly, we review the
literature on CG ratings. Secondly, we present a brief history of the CG in Greece. Then,
we present the structure of our CG rating methodology and the results. Finally, we
summarize the findings and procced with some critical points.

Literature on corporate governance ratings

Corporate governance (CG) has been a widely discussed issue among academics, capital
markets' regulators, international organizations and the business world. Shleifer and
Vishny (1997), define CG as the way in which the suppliers of finance to corporation
assure adequate returns on their investments. Agency theory is the fundamental reference
in CG. The agency problems vary, depending on the ownership characteristics of each
country. In countries with dispersed ownership structure (mainly the US and the UK) the
separation of ownership and control, as posed by Berle and Means (1932), refers to the
inherent conflicting interests of opportunistic managers and owners (Fama and Jensen,
1983; Grossman and Hart, 1986; Williamson 1985). Investors usually use their exit
options if they disagree with the management or if they are disappointed by the
company's performance, signalling - through share prices reduction - the necessity for
managers to improve firm performance (Hirschman, 1970). On the other hand, in
countries with concentrated ownership structure (continental Europe, Japan and other
OECD countries), large dominant shareholders usually control managers and expropriate
minority shareholders, in order to extract private control benefits. The agency problem of
CG is therefore posed as how to align the interests of strong blockholders and weak
minority shareholders (Becht, 1997).

In a period of volatile and uncertain markets, as shown by the recent corporate failures
and poor governance structures, demanding institutional investors seek to place their
funds in well-governed companies. Mainstream investors tend to examine and include in
their overall investment strategy whether companies comply with specific internationally
accepted CG standards. At the same time, as more investors evaluate CG when
purchasing stocks and mutual funds, an increasing number of listed companies feel the
pressure to take actions in order to adopt efficient CG policies and practices. As a
response to the increase in demand for CG evaluations, some investment research firms
and academic institutions are now developing CG rating services. A corporate
governance score is derived mainly by analyzing to what extent a company adopts codes
and guidelines of generally accepted CG best practices, and the extent to which local
laws, regulations, and market conditions encourage or discourage corporate governance

2
practices (Spanos, 2005; Xanthakis et al., 2003).

There are a few firms and academic institutions offering domestic and/or cross-border
CG ratings. Ratings are usually based on domestic and global CG codes and try to
determine whether listed companies comply with those standards and best practice rules.

Deminor has developed a methodology based on more than 300 CG indicators and offers
solicited CG ratings. Its services, which cover the main Western European markets,
include also investment advice on corporate transaction, proxy voting recommendation
and shareholder activism (Deminor, 2001). GovernanceMetrics International (GMI) has
also developed a CG rating system based on both public data sources and private
information (e.g. in-depth interviews with senior management and board members). GMI
rating criteria are based on more than 600 data points per company that cut across seven
categories: board accountability, financial disclosure, shareholder rights, compensation
policies, market for control, shareholder base and corporate reputation. The structure of
the rating system follows a number of internation codes, such as those developed by the
OECD, the Commonwealth Association for Corporate Governance and the Business
Roundtable. Companies are rated on a scale of 1-10 relative to one another (Sherman,
2004). Standard & Poor's (S&P's), the world-leading rating company, launch in 2001 a
new service (Corporate Governance Scores). A company Corporate Governance Score
(CGS) reflects S&P's assesement of a company's CG practices and policies and involves
the analysis of public and non-public information. The S&P's evaluation system analyses
four key componets: ownership structure and influence, shareholder rights and
stakeholder relations, financial transparency and information disclosure and board
stucture and process (Standard & Poor's, 2001; Bradley, 2004). The Corporate
Governance Authority, a Brussels based company founded in 2000, offers corporate
governance ratings worldwide. The rating system includes 225 questions which are
integrated into ten broad categories. The indicators are based on the OECD Principles of
Corporate Governance (1999) and incorporate both public and non-public information
(Corporate Governance Authority, 2002). In 2000, the German Society of Financial
Analysts (DVFA) developed a "Scorecard for German Corporate Governance" (DVFA,
2000), based on the German code of best practices. The scorecard is divided into seven
criteria: corporate governance commitment, shareholders and the general meeting,
cooperation between management board and supervisory board, management board,
supervisory board, transparency and reporting and audit of the annual financial
statements. In the German scorecard, each indicator is weighted by a suggested "standard
weighting" but also allows the reflection of individual weighting differences. The
German approach is applied in many countries in East Asian (e.g. Indonesia and
Philippines) and in Latin America (Strenger, 2004).

Most of the empirical studies examine the correlation of specific CG aspects and firms'
market value or performance. A relatrive limited number of studies use a CG index in
order to examine whether governance practices affect firm's market value. Black (2001)
examined the relationship between CG behavior and market value for a sample of 21
Russian firms by using CG rankings developed by the Brunswick Warburg investment
bank. A worst to best CG improvement predicts a 700-fold increase in firm value. The
author reported a powerful correlation between the market value and CG of Russian
firms. Durnev and Kim (2003) found that higher scores on both the CLSA CG index and

3
the S&P disclosure and transparency index predict higher firm value for a sample of 859
large firms in 27 countries. Gompers et al. (2003) showed the existence of a striking
relationship between CG and stock returns. The authors used the incidence of 24 different
provisions (primarily takeover deafness) of 1500 US firms measured between 1990 and
1999 to build a "Governance Index" and then they studied the relationship between this
index and firm performance. The "Governance Index" is highly correlated with firm
value. The study also evidenced that "an investment strategy that bought firms with the
strongest shareholder rights and sold those with the weakest would have earned abnormal
returns of 8.5 per cent per year". Klapper and Love (2002) used data on firm-level CG
rankings across 14 emerging markets and found a wide variation in firm-level governance
across countries. Black et al. (2003) constructed a multifactor CG index based primarily
on responses to a survey of all listed companies by the Korea Stock Exchange. They
found a strong positive correlation between the overall CG index and firm market value,
which is robust across OLS, 2SLS and 3SLS regressions, in subsamples, in alternate
specifications of the CG index, and with alternate measures of firm value.

A brief history of the evolution of corporate governance in Greece

Traditionally Greek companies were, and most of them still remain, family owned.
Family members were also board members and the company's executives. This kind of
structure did not give rise to thoughts on efficient corporate governance (CG), such as
there existed no agency problems between the owners and the management. However, the
significant use of IPO's as means for raising capital in the late 1990's turned these
companies from private-family owned to public listed companies, offered the first sign
that the long lasting operating methods had to be reconsidered. The speculative events in
the Greek capital market during 1999 led the Hellenic Capital Market Commission
(HCMC), the main independent regulatory decision-making body, and the state to take an
active role, introducing rules, regulations and codes of conduct. All these measures were
aiming at the protection of investors against market abuse, the improvement of the
transparency of the market and the establishment of appropriate business ethics. The
discussion on CG in Greece is focused mainly toward protecting individual and minority
shareholders' interests that are practically cut off from the decision making process of the
firm (Mertzanis, 2001; Spanos et al., 2004; Spanos, 2005).

Corporate governance appeared as an issue in Greece in the mid-1990s through an

introductory paper published by the Stock Exchange. The first, however, major step
toward the formation of a comprehensive framework on corporate governance has been
the publication of the "Principles of Corporate Governance in Greece" on October 1999
by an ad hoc committee co-ordinated by the HCMC (Committee on Corporate
Governance in Greece, 1999).

The Greek code contains 44 recommendations compiled on seven main categories:

- The rights and obligations of shareholders

- The equitable treatment of shareholders
- The role of stakeholders in corporate governance
- Transparency, disclosure of information and auditing

4
- The board of directors
- The non-executive members of the board of directors
- Executive management

The principles and best practice rules incorporated were closely modeled according to
OECD Principles on Corporate Governance (OECD, 1999). This, combined with an
announced intetion of the Ministry of the Economy to amend the corporate law to
incorporate additional CG elements that would then become mandatory, triggered an
open controversy between the representatives of the industrial federations and the state.
The former confirmed their belief in CG principles and support that voluntarily complies
is a sufficient incentive and thus firms should be self-regulated. The Federation promoted
its own code of conduct for its members. In May 2002 the Ministry of the Economy
amended the corporate law and incorporated fundamental CG obligations.

The legislative framework of the Greek capital market is now fully harmonised with the
guidelines and directives of the EU. Although improvements in CG have occurred in
Greece, they are mainly confined to a small number of large listed companies that are
more in tune with the international corporate stage.

The corporate governance rating system methodology

The approach

As the CG debate became a hot issue in 2000, the Center of Financial Studies in the
Department of Economics of the University of Athens launched a project financed by the
Stock Exchange, aiming at a pilot CG rating. The target of the project was to develop a
methodology on CG rating and apply it to a broad number of companies on a voluntary
basis (Tsipouri and Xanthakis, 2004). Specific targets were:

- To provide an independent and reliable tool for all investors who believe that a
thorough examination of CG practices will lead to increased long-term shareholder
value. The importance of the tool increases in a framework of a small open capital
market that aims to attract sophisticated international investors.

- To provide a comprehensive and specific rating regarding all CG criteria for each
company, enabling firms to use their individual results in order to measure
themselves against several benchmarks (high, average, sectoral average).

- To produce useful results of aggregated data for the relevant authorities (e.g. the
Stock Exchange, the Hellenic Capital Market Commission) and create an aggregate
score for the Greek listed companies participating, thus demonstrating strengths and
weaknesses to be taken into account for policy making.

- Form a basis for comparison with future exercises and offer a tool that will allow
correlation of the results with stock value and profitability to check the extent to
which investors pay a premium for companies with high ratings.

5
One of the main contributions of the project was the consensus that resulted from a very
close collaboration between the Stock Exchange (which financed the study and had a
vivid interest in practical results), an academic research center (which could guarantee
methodology and impartiality) and representatives of market participants (who provided
thorough inputs and assured the practical value of the results). In order to achieve the
highest possible consensus and obtain market-oriented outcomes, a Special Advisory
Committee on Corporate Governance was convened consisting of members of all the
relevant agents (the Hellenic Capital Market Commision, the Stock Exchange, the Athens
Chamber of Commerce & Industry, the Federation of Greek Industries, the Union of
Institutional Investors, the Hellenic Bank Association, the Brokers' Association) to advise
the researchers on practical matters related to their work. The Committee met as relevant
milestones were reached, and commented or recommended additional work.

The structure

The methodology consisted in the creation of a questionnaire reflecting the five chapters
of the Greek CG voluntary code, which basically replicate the structure of the OECD
Principles (1999). Other, well-regarded corporate governance codes were also taken into
account. The answers to this questionnaire were integrated into a number of indicators,
which did not have a 1 : 1 correspondence to the questions. The indicators were then
assigned with weightings, depending on their priority, so that a composite final overall
score could be obtained. More specifically the questionnaire consisted of five main
category-indicators:

- The rights and obligations of shareholders.

- Transparency, disclosure of information and auditing.
- The board of directors.
- Executive management.
- Corporate governance commitment, the role of stakeholders and corporate social
responsibility.

The total number of questions was 54, categorised into questions, which directly lead to
indicators suitable for the CG rating (32 questions), questions combined into one
indicator (16 questions leading to five indicators only) and questions used for
clarification and control not leading to any indicator (six questions). Of the former 32,
five questions received ipso facto the highest score because they refer to issues that are
mandatory in the existing regulatory framework. The reason the latter were included was
to show potential international investors that all listed firms in the Greek market comply
with these minimum standards.

The questions were thus integrated into 37 indicators, of which six were for shareholder
rights, nine for transparency, 12 for the Board, five for the CEO and the executives and
five for general issues like corporate social responsibility.

In 2004, an updated version of the scorecard was issued to follow the Greek law on CG
that had been published by the Ministry of Economy, as well as the recent trends of the
capital market and the business world.

6
Content of the main criteria

The rights and obligations of shareholders: The criterion reviews all relevant issues
related to the equal treatment of shareholders, like one-share one vote principle,
confidential voting, voting procedures and absence of takeover defence.

Transparency, disclosure of information and auditing: This checks the extent to which all
shareholders are equally and regulary informed, international accounting standards are in
place, efficient risk management system exist etc. The criterion also focuses on sufficient
disclosure of the board members' and executives' remuneration and deals with conficts of
interests between external and internal auditors.

The board of directors: This criterion evaluates board structures and functions, like CEO
duality, board independence, board size and meetings frequency, board committees, new
board members' rotation and training, non-executive directors' remuneration, non-
executive directors' election frequency etc.

Executive management: The emphasis is on the duties and responsibilities of the CEO,
executive managements' and CEO compensation, full information on stock options etc.

Corporate governance commitment, the role of stakeholders and corporate social

responsibility: The final criterion includes a mix of factors related to the external position
of the firm. We were concerned that emphasis on issues like stakeholder rights or social
responsibility might create a reluctance of companies to cooperate, as there has been a
clear tension between managers and shareholders on the one side and government on the
other in earlier years on such issues. While in the last decade this tension has diminished,
it was decided to limit question of this type to a minimum and also to attribute very low
weightings.

Calculation and weighting

Weighting was the greatest difficulty, as it inevitably had to include subjective

judgements. The way we proceeded was to first have each of the senior members of the
research team individually assign priorities amongst and within each category.
Fortunately, their assigned priorities coincided to a large degree, and where they did not,
agreement could be reached after discussion. Then, a score of 0 (inadequate), 1
(intermediate) and 2 (top performance) was assigned per indicator. These weightings
were presented to the Advisory Committee and were confirmed or altered to reflect the
priorities and the evaluation of the participants in the market.

The highest weighting was assigned in the category of transparency and disclosure,
followed by the shareholder rights, the board of directors, the executive management and
CSR.

7
Corporate governance rating for the large Greek listed companies

Sample and data

The dataset includes public information on 27 different corporate governance indicators

for the 20 biggest companies (based on the capitalization) in 2001 and 2003, as they
figure in the corresponding list of the Stock Excange (ASE/FTSE-20). The companies
included in our sample represent more that 70% of the capitalisation of the market. The
data is taken from the firms' annual reports as of year-end 2001 and 2003.

Results

The total rating results for the years 2001 and 2003, shown in Table I, demonstrated a
relatively satisfactory improvement (77.8% and 81.1% respectivelly). The highest
compliance in the Greek market is in the category of shareholder rights, followed by
CEO/Executive management and transparency. The Board of Directors category had a
medium compliance score, while weak compliance appears in the last category, which
incorporates external factors like committment to CG, corporate social responsibility and
the relations with shareholders. This ranking of the categories is also infuenced by the
impact of mandatory provisions, which are concentrated in the categories with the highest
compliance score.

----- take in Table I ----

As observed in the results of TableII, shareholders rights appear to be well protected in

Greece. The one-share one-vote rule is legally imposed. During the course of time the CG
ratings have been improved (94.3% in the 2001 survey and 100% in the 2003 survey).
Transparency and disclosure practices are of a quite high quality (Table III), with in-time
and undertsandable publication of the financial statements, and equal treatment of all
investors and financial analysts regarding information dissemination for important
corporate events.

----- take in Table II ----

----- take in Table III ----

Weaker compliance is observed in the disclosure of managerial remuneration (52.9% in

the 2001 survey and 57.5% in the 2003 survey), the application of the IAS (firms
employing the IAS or the US-GAAP are those listed in foreign stock exchanges – 58.8%
in 2001 and 60.0% in 2003) and the disclosure of company's risk management policy
(58.8% in 2001 and 60.0% in 2003). In the category "The board of directors", presented
in Table IV, large capitalization companies performed better in the 2003 survey
compared with the 2001 survey (70.5% and 67.9% respectivelly). A note-worthy feature

8
is that Greek firms seem to have a universal problem in the frequency of changing non-
executive directors. The introduction of the new law on CG in July 2002 increased the
number of non-executive and independent directors. Moreover, firms perform better in
the establishment of board committees indicator (47.1% in 2001 and 62.5% in 2003).
Table V, indicating ratings of the CEO and executive management, shows that the
FTSE/ASE-20 firms perform very well (81.1% in 2001 and 84.7% in 2003). The
weakenes lies in disclosure of share ownership information of the executive management.

----- take in Table IV ----

----- take in Table V ----

It came as no surprise that the degree of compliance is relatively low (Table VI) in the
last category that incorporates CSR and stakeholders issues (56.3% in the 2001 survey
and 63.1% in the 2003 survey).

----- take in Table VI ----

Conclusions and further research

The main conclusion drawn from this survey was that overall Greek companies
demonstrate a fairly satisfactory degree of compliance with OECD CG principle. The
introduction of the new CG law in July 2002 had a positive impact on the CG rating
results. However, there is still quite weak compliance concerning the role of stakeholders
and CSR, the non-executive directors' election frequency, disclosure of remuneration and
CEO/Chair split.

The merits and the limitations of the work undertaken can be summarized around four
main areas:

- Raising the issue: Following the increased interest on CG internationally and the
upgrade of the Greek market, the work undertaken really raised the issue and helped
shape a discussion on the potential merits of CG.
- Demonstrating market compliance: The exercise using practically all agreed
principles of the OECD could demonstrate a reasonable degree of compliance of the
average company rated. Its limitation in that respect is that it could not satisfy
investigations on convergence. The indicators used were highly pertinent to measure
compliance, but not convergence, which was not within the initial targets and would
need a longer time series analysis.
- Using "collective subjectivity" for the attribution of weightings: The Greek
methodology for the creation and valuation of weightings was different to those used
by academic publication or credit rating exercises. The idea of an academic
suggestion validated by all market participants was an effort to substitute for the
impossibility of longer term econometric testing. In the absence of initial data, this
method presents the advantage of passing the market test. It also contains a dynamic
aspect of change overtime, as attitudes and trends change in the particular market.
Weightings can be adapted accordingly. While inevitably subjective, these weightings

9
 took a more objective character through their validation by representatives from the
market. We believe that our innovative approach leading "collective subjectivity"
may be a good methodology substituting for the absence of databases, in particular
for smaller markets, where this exercise is easier to undertake.
- Identifying the potential to diversify tools based on the inputs used: As a first step one
can undertake scoring based on public domain information and make comparative
exercise that allow to rank firms or markets. If one wants to go deeper into the
investigation of CG quality in a firm, then it is necessary to enrich the exercise with
more indicators that are customized and result from in-depth research and interviews.

The rating attempt started practically in one type of a market (emerging with spectacular
rises in stock prices) and ended up in a totally different one: during the 18 months that it
took to design the methodology, test it, validate it and apply it to the sample used, the
Greek market was upgraded to a developed market and the Stock Exchange suffered
higher losses than the average of all developed markets. In this context, needs, prospects
and expectations from this exercise changed and led to different requests from the various
participants involved. These requests led to new discussions on how the existing
indicators could be valorized by alternative calculations or how they could be enriched in
the future to cover the newly emerging requests.

Our sample contains large capitalization quoted companies. Moreover, some of the
companies are internationally quoted. For them, the interest does not lie in their
comparison with Greek companies or with basic OECD principles, but on their potential
to compete for funds globally. Finally, our approach could be applied in many small open
economies. This particularly applies to counties that still have to develop a
comprehensive legal and transparent basis for corporate governance.

10
 Tables

Table I: Total CG rating results based on public domain information

for the FTSE/ASE-20 companies (maximun=100%)

Corporate governance indicator 2001 2003

The rights and the obligations of
94.3 100.0
shareholders
Transparency, disclosure of
80.1 81.4
information and auditing
The board of directors 67.9 70.5
CEO and executive management 81.1 84.7
Corporate governance commitment,
the role of stakeholders and corporate 56.3 63.1
social responsibility
Total CG index 77.8 81.1

Table II: The rights and the obligations of shareholders (maximun=100%)

Corporate governance indicator 2001 2003

The equal treatment of shareholders 100.0 100.0
Absence of takeover defense 94.1 100.0
Existence of organized and
94.1 100.0
autonomous shareholder department
Voting procedures in the GMS 100.0 100.0
Mechanisms of sufficient and timely
information about the dates, place and 86.8 100.0
agenda of the GMS
Mechanisms through which
shareholders are sufficiently and
91.2 100.0
timely informed on the proposals
submitted in the agenda of the GMS
Total index 94.3 100.0

11
Table III: Transparency, disclosure of information and auditing (maximun=100%)

Corporate governance indicator 2001 2003

Report of the annual and semi-annual
financial statements 100.0 100.0
with clear and understandable way
In time publish of the annual and semi-
100.0 100.0
annual financial statement
Equal treatment of all investors and
financial analysts regarding information
100.0 100.0
dissemination (fair disclosure) for
important corporate events
Detailed analysis of any deviation from
previously announced earnings targets 88.2 90.0
and strategic goal
Application of an internationally
recognized accounting and auditing
58.8 60.0
system for the balance sheet consistent
with the IAS
Disclosure of board directors and
executive staff members' 52.9 57.5
remuneration
Specific discussion of the company’s
risk management system on the annual 58.8 60.0
report
Total index 80.1 81.4

12
 Table IV: The Board of directors (maximun=100%)

Corporate governance indicator 2001 2003

Division between the role of the
29.4 45.0
chairman and the CEO
The composition of the board of
88.2 88.8
directors
Non-executive board directors'
76.7 80.0
independence
The size of the board of directors 88.0 60.0
Board meetings frequency 100.0 100.0
Establishment of board
47.1 62.5
committees
Non-executive board directors'
0.0 0.0
election frequency
Total index 67.9 70.5

Table V: CEO and executive management (maximun=100%)

Corporate governance indicator 2001 2003

The duties and responsibilities of
100.0 100.0
the CEO
Disclosure of share ownership of
the executive management staff 52.9 60.0
members
Existence of position of Chief
88.2 90.0
Financial Officer
Total index 81.1 84.7

Table VI: CG commitment, the role of stakeholders and CSR (maximun=100%)

Corporate governance indicator 2001 2003

Existence of written CG rules in
41.2 42.5
the company
Existence of a Corporate
Governance Committee or
29.4 55.0
individual entrusted with CG
compliance issues
Existence of an efficient CG
framework taking account the 64.7 62.5
interests of all stakeholders
Corporate social responsibility
97.1 97.5
and environmental awareness
Total index 56.3 63.1

13
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