What is governance risk in investing?

A company can have good products and growing sales and still hurt investors if it is badly run. That danger is called governance risk. This page explains what governance risk means, common warning signs and the rules that try to reduce it in India.

Quick answer

Governance risk is the risk that a company's leaders, board or internal controls fail to act in the interest of shareholders, leading to losses. It includes accounting fraud, misuse of company money, unfair related party deals, weak boards and poor disclosure. Problems of this kind can cause sharp falls in share prices, even in companies that look strong on the surface.

Key takeaways

• Governance risk comes from how a company is run and overseen.
• Red flags include auditor resignations and high promoter pledging.
• Related party deals can move money away from shareholders.
• SEBI's LODR rules set governance standards for listed firms.
• It is the 'G' in ESG analysis.

What is governance risk?

Corporate governance is the system of rules and practices that decides how a company is directed and controlled. It covers the board, management, auditors and how they treat shareholders. When this system is weak, the risk of harm to investors rises.

This kind of risk is often hidden until something goes wrong. A company may report good results for years before a problem comes to light, and then its share price can fall very sharply.

Common red flags

Another warning sign is a big gap between reported profits and actual cash flow over several years. If profits keep rising but cash does not, it is worth looking at the accounts more closely.

A lesson from history

In January 2009, the chairman of a large Indian IT services company admitted that the company's accounts had been inflated for years, including cash balances of thousands of crores that did not exist. Its share price collapsed, and the case led to major reforms in Indian corporate governance.

Such cases show that strong headline numbers are not enough. Investors also need to judge whether the people running a company can be trusted.

How do rules reduce governance risk?

The Companies Act, 2013 and SEBI's Listing Obligations and Disclosure Requirements (LODR) Regulations, 2015 set governance standards for listed companies. They require independent directors, audit committees, approval for large related party transactions and timely disclosures.

Auditors must report on internal financial controls, and companies must disclose the reasons if an auditor resigns. Proxy advisory firms also review resolutions and advise shareholders on how to vote.

How investors can assess it

Read the annual report, especially the auditor's report, related party disclosures and corporate governance section. Track promoter holding and pledging, and note any regulatory actions against the company or its leaders.

Governance risk is the 'G' in ESG. Paying attention to it does not remove risk, but it can help you avoid companies where the people in charge may not act in your interest.

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