Tuesday, May 11, 2010

Corporate Governance Ratings – What Are They Good For?

Way back in 1970, there was a Motown record that had as its catch phrase, “War, what is it good for? Absolutely nothin’!” Today, there is research that suggests that the same can be said about corporate governance ratings.

For the past ten years or so, investor relations practitioners have been drawn into the debate on corporate governance. It’s not that IR practitioners have a special expertise in corporate governance, or that many of them really want to become experts. It’s just that Boards of Directors have been under increasing scrutiny to comply with a list of “best practices” compiled by groups such as Institutional Shareholder Services (“ISS”), Governance Metrics International (“GMI”) and The Corporate Library. Directors do not like it when shareholders withhold their proxy votes for failure to meet minimum corporate governance scores. And it’s investor relations that talks to the shareholders, so IR people find themselves working with the Corporate Secretary and the General Counsel to find out how they can achieve the highest possible corporate governance scores to present to shareholders while actually changing corporate practices as little as possible.

The underlying premise of the governance rating services is simple, yet compelling on its surface: companies that focus on corporate governance as indicated by high ratings will, over time, generate superior returns and economic performance and lower their cost of capital. Conversely, companies weak in corporate governance as shown by low governance scores represent increased investment risks that should be penalized by a higher cost of capital.

But did you ever take a step back and wonder whether the corporate governance ratings have any value in actually predicting poor corporate governance or performance? I certainly have. And so too, it seems, have Professors Robert Daines of Stanford, Ian Gow of Kellogg and David Larker of Stanford. In a recent scholarly article, “Rating the Ratings: How Good Are Commercial Governance Ratings?” which is to be published in a forthcoming issue of the Journal of Financial Economics they look at how effective corporate governance ratings are in helping shareholders figure out if companies with high corporate governance scores are actually better governed. The findings are so startling and unequivocal that I am going to quote the article abstract in its entirety:

Proxy advisory and corporate governance rating firms (such as RiskMetrics/Institutional Shareholder Services, GovernanceMetrics International, and The Corporate Library) play an increasingly important role in U.S. public markets. They rank the quality of firm corporate governance, advise shareholders how to vote, and sometimes press for governance changes. We examine whether commercially available corporate governance rankings provide useful information for shareholders. Our results suggest that they do not. Commercial ratings do not predict governance-related outcomes with the precision or strength necessary to support the bold claims made by most of these firms. Moreover, we find little or no relation between the governance ratings provided by RiskMetrics with either their voting recommendations or the actual votes by shareholders on proxy proposals.

Inside the article the language is even stronger. Here’s my favorite quote: “One especially interesting result is that CGQ (perhaps the most visible governance rating) [Corporate Governance Quotient, a measure devised by RiskMetrics/ISS] exhibits virtually no predictive ability, and when CGQ is significant, more often than not it has an unexpected sign (e.g., higher CGQ seems to be associated with lower Tobin’s Q, and in some models more class-action lawsuits).” In other words, high governance scores have virtually no value, and companies that put in all of the so called best practices are actually more likely to be worth less and get sued more often.

What all of this suggests to me is that good oversight by the Board of Directors and good management of the shareholders’ assets is not a function of a formula or a list of practices. Rather, the way Boards and managements function needs to be examined by investors on a case-by-case basis in relation to their cultures and their track records. How Boards function does need more transparency so that investors can judge for themselves if they are practicing good stewardship. But those that think that good governance can be boiled down to a single number score are just kidding themselves. And if you are paying to get advice on how to increase your governance scores, you’re wasting corporate assets.