Governance Quality on Financial Distress

Financial crises often stems from deficiencies in internal Corporate Governance (CG) practices as witnessed in some of the recent corporate scandals. An efficient CG mechanism can safeguard shareholders’ interests by curbing managers’ self-serving behaviour and mitigating agency conflicts (Fernando et al., 2020). Effective governance structure could prevent Dcorporate collapse, reducing the likelihood of bankruptcy. One of the prominent methods to address this issue is by separating ownership and management thus reducing the information asymmetry between managers and shareholders (Sewpersadh, 2022). Duality can manifest and result in various forms, including overcompensation, excessive perquisites, empire-building, fraudulent activities, and increased risk-taking behaviour (Daily and Dalton, 1994).

The study was conducted using twenty-six governance indicators across four dimensions: ownership structure, board composition and structure, board subcommittees, and financial transparency and disclosure over a period of 16-year financial data from 2008 to 2023. A longer time period was chosen to assess the deteriorating financial health or enhance the predictability of potential distress. Data of 2080 listed firms on National Stock Exchange of India (NSE) was obtained and classified as distressed or non-distressed based on certain pre identified criteria.

The power dynamics within the board can significantly impact financial distress and may manifest as either a monistic or dualistic structure. Based on resource dependency theory, prevailing evidence suggests that a dual structure enhances monitoring and facilitates smoother functioning by minimizing conflicts, specifically during financial distress. A panel Logistic Regression (LR) was used to understand the impact of the variables on financial distress. LR is a linear classification model with the fundamental assumption of optimization of model coefficients by maximizing the log-likelihood function (Zhang et al., 2022). It requires fewer restrictive assumptions of multivariate normality and covariance matrices and is comparatively unaffected by outliers due to the nonlinear transformation of data (Pindado et al., 2008).

The regression results on the relationship between the identified variables and financial distress reveal a substantial negative association between most variables and financial distress. ICGQ and FD. The remarkably low odds ratio implies a significant decrease in the odds of financial distress with an increase of one unit of the identified variable. The findings suggest that, as the overall quality of CG improves, there tends to be a decrease in the likelihood or severity of financial distress. The findings of this study align with agency theory and related literature, suggesting that enhanced governance practices can resolve deficiencies in internal CG, leading to a reduction in the likelihood of financial distress (Ali et al., 2018; Kabir et al., 2020; Younas et al., 2021). The probable rationale for the findings is that effective governance structures can safeguard against corporate collapse, foster sustainable corporate performance, enhance the firm value, and reduce the likelihood of bankruptcy. The findings highlight that the conflict arising out of separation in ownership and management in financially distressed firms can be addressed with an efficient CG mechanism (Fernando et al., 2020).

The findings align with prior research by Li et al. (2021), Cao et al. (2015), Chiang et al. (2015), Ashraf et al. (2022), and Younas et al. (2021) in reporting that institutional investors may serve as reliable indicators of a company’s financial health and can reduce the likelihood of financial distress. These findings also align with the efficient monitoring and management disciplining hypotheses suggesting that institutional investors, as influential owners controlling a significant number of shares, have the resources and incentives to monitor management and enhance firm performance. Further, they possess superior knowledge and monitoring capabilities compared to other shareholders, leading to lower default risk. Further, it is observed that higher holdings by executive directors and chairpersons indicate that their decisions are aligned with those of shareholders, minimizing agency conflicts and the likelihood of financial distress (Fernando et al., 2019; Luqman et al., 2018; Manzaneque et al., 2016; Miglani et al., 2015; Sewpersadh, 2022).

Another significant finding suggests that effective board composition, characterized by a higher number of independent directors and gender diversity, can reduce the likelihood of financial distress. Board independence enhances creditors’ confidence by curbing managerial opportunism and self-serving behaviour, as independent directors may not engage in actions that are detrimental to shareholders’ interests (Cao et al., 2015). Further, independent directors exhibit stronger motivations to perform effectively, curtailing the dominance of the CEO and demanding additional meetings to scrutinize the board’s agenda. This possibly leads to enhanced performance and reduces the likelihood of financial distress (Mangena and Chamisa, 2008; Manzaneque et al., 2016; Appiah and Chizema, 2015; Fernando et al., 2019; Mariano et al., 2020; García and Herrero, 2021; Li et al., 2021). The findings highlight the importance of robust governance practices in mitigating financial distress risk. Notably, higher institutional and chairperson holdings are linked to a reduced likelihood of financial distress, suggesting the role of institutional investors in signalling a company’s financial health and mitigating financial distress risk.

The findings also suggest that a diverse and independent board structure enhances governance practices, improves firm performance, and reduces the likelihood of distress. The presence of independent members and chairman’s independence in audit committee is found to enhance financial reporting quality and reduce the risk of fraudulent practices. Regulators, especially those overseeing insolvency processes can utilize these findings to comprehend governance challenges faced by companies under their purview. Addressing the governance concerns, managers can enhance transparency and accountability, ultimately fostering investor confidence and improving long-term business performance. Similarly, investors can use this information to make informed decisions, mitigating risks associated with poor governance practices and maximizing shareholder value.